Vol #112: January 12th, 2023
There’s nothing quite like hitting a home run.
A batter that can reverse the course of a 2.9 inch sphere rocketing at over 95 miles per hour earns the gasped silence of a stadium crowd.
The dinger hinges on some very simple physics. How fast can the batter swing the bat, and at what angle does he make contact with the ball? Louisville birchwood, meet five and a half ounces of white leather red stitched around a rubber core. Pop!
It’s no surprise then that Major League Baseball spends a lot of time thinking about exactly what goes into a bat and a ball. When Sammy Sosa “accidentally” picked up a corked bat he used for “training”, it rightfully caused a scandal. Umpires change the game balls out even for the most minor scuffs, so as not to give the pitcher any extra sauce for his meatball.
The beauty of a goal in soccer, or a touchdown in football, while equally thrilling, are far more complex scenarios. There are numerous moving parts that must come together for either of these to be achieved. Open field dynamics with blockers, runs, and passes, must all coalesce into the ball crossing the line.
Deflategate notwithstanding, a simple tweak to the pigskin or European football is unlikely to have a profound effect on the dynamics of the game. Letting batters use a metal bat, or pitchers keep shinola on the mound however, would dramatically alter the ballpark experience. (While the MLB hasn’t touched these two sacred components, they have toyed around with more minor rule changes to make the game more exciting).
Market structure has its own set of lynchpins. The corked bat equivalent would be a change in tick sizes, immediately impacting the way markets trade.
The SEC dropped a holiday present last month for rules geeks in the form of a 256 page proposed update to the National Market System (NMS). While it details some sweeping changes to payment for orderflow and access fees, their impact will be more nuanced and slow moving. What has everyone aflutter is the potential for reducing the tick sizes of equity markets.
According to a supporting statement by Commissioner Mark Uyeda, “Due to the technological changes since Regulation NMS was adopted, including the massively increased speeds and processing power used in electronic trading, the market standard known as “tick size” ought to be reconsidered.”
The tick size is the minimum increment at which a price can be quoted electronically. Through auctions, block trades, or other price improvement mechanisms, trades can take place at more granular levels, but the regulated width has a profound impact on traded prices.
Reconsidering this is a gargantuan task that will bring out the big guns. Equities markets are the backbone of capital formation, and playing with their core rule base will create many winners and losers. Options traders are interested because they dearly remember their own tickrement tinkering, and wonder what comes next.
In equity options, there are two types of issues, “Pennies” and “Non-Pennies”. Since 2007, the most actively traded stocks have been granted Penny status, and can be quoted a penny wide (versus a nickel) for options priced less than $3. There are only 363 penny denominated classes, less than 10% of overall listings.
Traders still ask “is that a penny stock” as a proxy for liquidity and opportunity. This change was an ongoing debate, so much so that the “Pilot” had to be extended numerous times, and was only finally added as a formal rule in June of 2020. That was over a decade after Whole Foods Markets Inc was the first of thirteen original
The rollout was fraught with exchanges, customers, and liquidity providers all lobbying around rulemaking for how the cheese was divided. Savvy, electronically focused firms pushed for more penny classes as they knew they could out-compete, while exchanges had to look at their server costs and consider how many more updates they were going to have to process. Customers liked the idea of better pricing, but they also didn’t want more execution complexity.
The ultimate question for the industry was whether this would bring more liquidity. Everyone will align behind something that increases volumes and trading activity. Rising liquidity is a tide that lifts all boats. A pitcher won’t like the idea of his ERA doubling from the introduction of corked bats, but if more home runs means more fans, his salary probably goes up too.
There are two camps of thinking about how to improve liquidity. Is it better to have bigger markets, or tighter markets?
At first blush the answer seems obvious - of course we want tighter markets. Even the SEC chairman at the time fell into this simplistic line of thinking. Cox showed scintillating incisiveness upon the announcement, reminding us that “quoting in penny increments has the potential to permit investors to trade options at better prices.”
If I can buy AAPL June 150 calls for $1.48 instead of $1.50, now I have both convexity and change for a cup of coffee. That’s all well and good for the retail customer who wants to buy the 3 calls offered at $1.48, but what if I want to buy 100 calls?
When the minimum increment is wider, marginal liquidity will tend to pool at these wider decrements. Any market maker who was willing to sell that call at $1.48, would display their interest at $1.50. They will also display the size they would theoretically trade at $1.49 and $1.50.
A market maker's demand (bid) or supply (offer) function is nonlinear. The amount they are willing to buy or sell scales exponentially as you get further away from the theoretical value.
If you have the AAPL calls worth $1.45, then you might sell 3 at $1.48, 7 at $1.49 and 15 at $1.50. If $1.50 was the lowest price you could show, your electronic size would be 25. And if someone came looking to buy 100, you might fill them at $1.55. (The curve keeps going up until it stops. If you get a call to sell 10,000, start thinking twice about your assumptions no matter how much edge you’re getting.)
In theory when you increase the granularity of the tick size, you give the market participants a more precise way to express this demand (supply) function. The small retail order gets to pick up their 3 lot at a better price, and a larger order would see some degree of price improvement as they drilled through multiple levels to get their fill.
The dynamics of electronic markets make this question more complicated. With trades taking place at multiple levels, it might actually cause liquidity to decrease, because of defensive positioning and risk management by market makers.
If the original 3 contract order went to the exchange to pay $1.50, it would barely put a dent in the quoted offer size. There would be other players offered there, and even if it was a single player trading 3 of 25 wouldn’t move the market. Why should it - it’s a small uninformed hedger or speculator.
If that order instead clears the market at $1.48, the other offers behind now have a chance to think - ‘hey someone is bidding this up, I should move my prices’. With liquidity fragmented across 16 exchanges, market makers have to react very cautiously to moves in prices, as they have billions of dollars in potential exposure.
Now for that larger customer to get a fill they would have had all in one place at $1.50, they start spooking the market buying up smaller sizes and ultimately drive the price away from them.
There are also practical reasons for having a minimum tick size. If the tick size is too small, it can create a perverse dynamic where firms are making economically insignificant pricing updates. This is a burden for exchanges that have to process that, but also users who see a whole lot of flickering noise.
Time priority is an important factor for building liquidity also, and too small of a tick size would eliminate that. In the camp of bigger markets, allocation priority is given based on a traders size relative to the market size (pro-rata). This encourages dealers to size up.
In the tighter markets corner, allocation priorities are given based on the time the order was sent in. The first in line gets their size first, because they took the initiative to step up and improve the price.
There’s no right answer to which is better for liquidity, you need both. Combined incentives of tighter markets or bigger markets on different exchanges are a unique feature that boosts overall option market liquidity. If the tick size is drawn too small, you effectively eliminate time priority because someone can queue jump with a meaningless price update.
What’s also curious about this tick size change, is that fairly recently the opposite was tried with somewhat negative effects. A 2014 congressional bill mandated that the SEC perform an experiment to evaluate the impact of wider tick sizes in small cap names, under the assumption that this would boost liquidity, create jobs, and guarantee talking heads had something vacuous to brag about.
The result of the 2016 study was exactly the opposite of what the politicians expected, but the market participants wrenched into this charade were none too surprised. While there was greater size on the wider markets, volume stagnated and the effective spread paid actually increased. Orders were slower to get filled and more orders were left unfilled - i.e. more missed opportunities.
None of this means that going the opposite direction will have the opposite effect. Markets are complex, organic mechanisms, and must be studied intentionally. The benefits of tighter markets on investors bottom line is obvious at trade time. What’s less clear are the second and third order effects of more detailed pricing.
The comment period on this rule proposal is open through March 31st, and even then it will be several years before all of the plumbing can be put in place to make this a reality. But it will be interesting to see how many places we’ll get after the decimal point in future AAPL orders.