Decimalization,adverse selection,and market maker rents |
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Affiliation: | 1. Mechanical Engineering Department, Khalifa University of Science and Technology, Petroleum Institute, Abu Dhabi, United Arab Emirates;2. Mechanical Engineering Department, Imperial College London, London, UK |
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Abstract: | I address the issue of how decimalization impacts the information acquisition decision of traders. I show that traders have less of an incentive to improve the quality of their information and, consequently, trades tend to be less informative following a reduction in the minimum tick. This result is consistent with the empirical finding that reductions in the minimum tick lead to declines in the adverse selection component, a finding counter to the theoretical predictions in the literature. This result also explains how the predicted savings from decimalization can exceed even total market maker profits. In addition, I show that even if market makers are perfectly competitive, a minimum tick can lead to multiple spread equilibria, some of which being more than one tick away from the underlying, or “no-tick”, equilibrium spread. Finally, I discuss the implications of the model for payment for order flow/internalization and the existence of an optimal tick size. |
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