By Louisa Chender
Tick sizes are a crucial element of a contract specification that exchanges must contend with.
The goal is to protect investors by imposing a minimum price change for quotes of bids and offers, ensuring that everyone is moving the price at the same increments.
Ultimately the tick size contributes to shaping overall market quality as well as the trading costs paid by end users.
Tick size reductions on exchanges across the globe have shown that smaller ticks can result in significant cost savings to the buy-side.
One recent example of this follows CME Group’s decision to reduce the tick on 2-year note futures in January.
After halving the tick size, the Chicago-based exchange said it managed to reduce the cost to trade in ticks by as much as 36%.
The average top of book spread traded initially at the minimum tick for more than 94% of the trading day during regular trading hours (see image). As of June, this has gone up to 97%.
Trading volumes went up as expected and open interest soared as allowing people to enter the market at more granular price level brought about more opportunities to trade.
Yet despite some stand-out benefits for exchanges and end users, tick sizes on many benchmark futures products have been left unchanged for years.
Jigar Patel, global head of business development at electronic market-maker XTX Markets, said: “Regularly reviewing tick sizes to ensure that they are balanced, i.e. neither too small nor too large, is one of the key roles of a venue. Unfortunately many benchmark futures have not been updated in decades and have lagged the widespread electronification of the market.
“This ends up costing the buy-side because extremely large tick sizes prevent spreads from naturally narrowing: many benchmark futures are ‘tick-constrained’ over 99% of the trading day,” Patel said.
As with any change it is difficult to please all participants given their varying strategies and needs, so getting the balance right is a challenge.
The right tick size
“There is a right tick size, which differs from product to product, depending on the liquidity in the product and the expected execution cost in this specific product,” said Rick van Leeuwen, head of institutional trading at Amsterdam-based market-maker IMC.
The more liquid the product is, the more likely it is that you can get a tight tick size because there will be more people that show something on the best bid and offer.
This will save money for the buy-side because the spread will be small.
“One note to this is that there are limitations to how small a tick size can be,” he said.
For example, a smaller tick size increases the load for exchanges because there are significantly more incremental price updates.
Another risk is that if the tick is too small it will look like there is less liquidity available which can turn-off investors.
“I would say tick sizes should be determined on the liquidity of the product and exchanges should think about what kind of basis point it should be,” van Leeuwen adds.
“They should also think about how the products relate to eachother – for example futures and options.
“If one product has a smaller tick than another it will impact the other. Similar products with the same underlying should have a similar tick in my opinion.”
The liquidity test
German exchange Eurex reduced in 2017 the tick size on STOXX Europe 600 futures for calendar rolls, responding to the need to be a friendly environment for passive holders who incur costs as they roll their contracts over four times a year.
Zubin Ramdarshan, head of equity & index product design at Eurex, explains that the change was specific to the calendar roll to avoid a huge impact on trading behaviours that could have occurred with a change to the outright.
“Tick size is a sensitive topic but calendar is less so,” he said.
However, because the outright order book and calendar order book are connected by synthetic matching, Eurex had to switch that off and separate them out.
“When you do that you hope to have the liquidity providers - which did step in. Members participated in the roll that were not there before,” Ramdarshan said.
“We saw a drop in blocks and increase in order book trading, so the desired impact happened.”
Acknowledging that changes invariably can be a cost to members, Ramdarshan said it’s important to ensure the cost is outweighed by the benefits.
“The key point is does it improve liquidity and grow liquidity.”
He said STOXX 600 was a test, and, looking at the data, it passed.
Eurex was set to reduce the tick on Euro STOXX Banks and STOXX Europe 600 Banks from 0.1 to 0.02 in July.
Depending on its evaluation of the new changes next year, Eurex could be left questioning whether this something it will want to roll out to other products.
“If it improves liquidity and members are happy, I don’t see why not,” Ramdarshan said
Savings vs earnings
Mark Phelps, group chief executive officer of clearing broker GH Financials, said alterations to tick sizes should be implemented to encourage price competition.
“There is a strong rationale for finer pricing in products that have met the minimum price but not for markets that trade with a two or three tick wide market, such as energies,” he said.
For example in a close to zero interest rates environment, finer pricing in short sterling makes sense.
“I am not an advocate of reducing central order book tick sizes lower than they currently are in short term interest rates but you can see that in the wholesale market there is a demand for finer pricing.”
The incentive for end clients and market makers is they get a better price, while exchanges would want finer pricing in their products so there are more price levels to trade.
But there is no correct answer to this as different market segments will have very different opinions.
“I think smaller ticks is probably where we will end up going. Markets are generally driven by what the end user wants and if the end user demand for finer pricing is there exchanges will need to put in what they want,” Phelps explains.
However, there is a balance to be struck between cost savings for end users and P&L for proprietary price makers.
“There is no point in focusing on what the end users want at the cost of what the props can make in terms of liquidity, and that is what the exchanges will be trying to weigh up when they try to bring in finer pricing.”
Price determines the tick
European market Euronext introduced in 2007 a premium-based tick size regime on its Amsterdam equity options market which allows the price at which participants want to trade determine the tick size.
For orders entered with prices below the premium the tick size is €0.01 and above, the tick size is €0.05.
The threshold was initially set at €0.20, and increased to €0.50 one year later, meaning a higher value of the price could be entered with €0.01.
Euronext rolled the regime out to Brussels equity options in 2010 and then to its AEX-index in 2013, further increasing the premium to €5.00 for stock options on the latter.
“We had to come in at a certain level which is why we started looking at a low level in 2009.
“But then everyone saw the effect and agreed that we could increase the threshold because there are more trading opportunities in the lower tick size,” Hein den Hertog, senior product manager at Euronext, said.
One of the main effects when initially introduced was that it reduced the best bid and offer spread.
“People were using the tick size to get a smaller spread and taking the opportunity to enter the market at €0.01, so we saw it as a positive effect,” Hertog added.
Markets determine the price
Paul Lynch, chief executive officer of Swiss algo trading firm Itarle, points-out that the bid-ask spread represents an element of two-way risk and one of the ways of pricing that risk is volatility.
“The short-term contract micro-structure is influenced by the tick size, queue lengths and volatility,” he explained.
If it is trading at minimum tick but there are plenty of up and down ticks then it is probably a healthy micro structure.
“Where you have a case where the high and low of the day is just one bid and ask quote, the tick size is clearly too big and there will not be enough willingness to signal that you are a buyer or seller – then it certainly needs looking at,” Lynch said.
“However, in conjunction with healthy volatility, the tick size is probably acceptable.”
Another consideration is that even by looking at the same contract with different durations it seems the market determines the pricing.
Using fixed income derivatives as an example, on the short end the front months are trading at minimum ticks 95% of the time but further out it tends to converge at a minimum tick size quote only 20% of the time.
“Typically markets will determine the bid-ask spread for a contract over time and different trading conditions,” he said.
Lynch does not see there is a desire for an infinitesimally small ticks because that leads to lower volume on bid and ask.
“If it is too small it is just people competing on price with little size. Too wide, it is people competing on time because the price won’t move throughout the day.
“The tick size has to be a representation of risk.”
One size doesn’t fit all
Andy Ross, chief executive officer at CurveGlobal, said the general challenge if you want liquidity is that there is a significant amount of risk available at a certain price point.
“If you have lots of granular ticks that could spread the liquidity up and down the pricing structure. There is an efficiency frontier and that is difficult to determine,” he said.
CurveGlobal, the London Stock Exchange Group’s interest rate derivatives venue, set out to challenge the status quo when it launched in September 2016.
One example of this is opting for half ticks (0.005) for both short sterling futures and Sonia futures.
But finer pricing was not the overall objective.
“It is not our job to tell people how to trade, but to allow people to trade in a way that both the buyer and seller can transfer risk in the most efficient way - one size does not necessarily have to fit all,” Ross said.
Curve is instead set on coming up with alternatives and innovative opportunities for traders.
For example it introduced adaptive pricing on block trades, whereby fractional pricing is created using multiple blocks, offering greater choice on price granularity (see image).
Ross said there are areas where the futures market can learn from the over-the-counter and inter-dealer markets based around multi-broker RfQs (Request-for-Quotes).
“What we allow is the broker to ask the market and get prices in order to find the best bid and best offer. At the front end of the curve that tends to be between the bid and offer.”
Therefore the price-taker is getting a price they are comfortable with and the price maker is getting all of their order filled.
This opened the door for people to execute trades that they wouldn’t do elsewhere.
Curve’s chief said it’s not just about challenging the orthodox on things like tick, but how you can trade better. Essentially granular pricing is nothing new.
“This is almost like back to the future where you could have worked something on the floor down to a finer price,” he said.
Ross reiterates that the markets will continue to evolve in search for more efficient ways to trade, and the tick size is just one of many moving parts.