V is for Volume, and Its Implications for the Access Fee Pilot
We’ve recently talked about how liquidity provider incentives do add to market quality, and also talked about how tick-constrained stocks have more depth, thanks to their wider spreads.
Today we’re taking a deeper look at the economics of quote depth and spread, using data that is already in the market.
Tick Pilot found liquidity provision was indifferent to tick size
We start with more good, but mostly ignored, data from the tick pilot.
Sitting on page 14 of the Tick Pilot Assessment is a really interesting chart. It compares the accumulated depth as each pilot group moves further from midpoint of the market bids and offers. Although pilot stocks were trading on five-cent ticks (Groups 1 and 2), control stocks were still trading on one-cent ticks. What the chart shows is that accumulated depth is almost identical five cents away from mid (ignoring the trade-at group [G3], where lit liquidity actually improved).
What we see is that liquidity away from mid forms in the same V-shape, regardless of tick size. An economist might think of these as the instantaneous supply and demand curves for stocks—where the tick size does NOT change the slope of the curve—and therefore the elasticity of demand is indifferent to tick size.
Chart 1: Total available liquidity is a function of distance from mid, regardless of tick size
Source Tick Pilot Assessment (April 2017 data)
What is less obvious, is that the cost of instant liquidity went up with the wider ticks.
Based on the data in the chart, anyone wanting to buy 5,000 shares could do so by sweeping five levels of the control stocks or lifting the Tick Pilot group offer. However, the average cost of buying the control stocks was two cents cheaper thanks to the averaging in at lower price points. Importantly, even though the elasticity of supply was the same, the cost of instant liquidity was lower with volume at tighter spreads.
The IBKR switch seems to confirm this
Interestingly, the recent transfer of IBKR to IEX seems to confirm this V-Shaped phenomenon.
Through Oct and November, IBKR saw it’s:
- Spread increased 100% (from five cents to 10 cents).
- Depth increase 44% (from 396 to 571 shares).
Chart 2: IBKR spread and depth while listed on Nasdaq, and then IEX
Source: Nasdaq Economic Research
Sept – Nov 2018 data (Dec excluded as market volatility made both the spread and depth worse)
Again the V-shaped trade-off between spread and depth seems to exist, and makes economic sense:
- We’ve seen that a lack of incentives affects the economics of posting lit quotes, which discourages a competitive spread.
- Speed bumps are an additional economic penalty to market makers, as they delay the ability to confirm cancels or hedge, which may support the unexpected reduction in depth. It’s worth exploring more, later.
- The flattening of the depth V-shape in IEX has also increased the cost of liquidity. Using the math from above, buying 500 shares now costs 65% more than what it did before.
How do venue economics affect one-cent spread markets?
What we have observed above is interesting, but what does it mean for all those stocks that trade one cent wide already. It’s time to look at venue micro-economics.
Although your screen will show you a bunch of liquidity at the NBBO (National Best Bid and Offer) the reality is that none of those quotes truly “cost” nothing to trade. The different rebates and fees charged have a small but important impact on the economics of spread capture.
Chart 3 shows the real economics for liquidity providers in each venue. Note that:
- All venues are positioned (on the horizontal axis) to show the true spread capture, after costs.
- The height of bars is representative of the typical market share that each venue trades.
Importantly we once again see the V-shaped curve, where more liquidity is available at a true 1.6-cent spread (so called maker-taker markets) than a true 0.6-cent spread (often called inverted markets), as expected based on our observations above.
Chart 3: All venues add costs that result in spread capture different to the one-cent displayed quote
Click image to see full-size version
Source: Nasdaq Economic Research (Bar height shows market share)
So what’s this got to do with the Access Fee Pilot?
The Access Fee Pilot is all about reducing rebates able to be paid to liquidity providers. Rebates are what allows exchanges to incentivize liquidity and create a true 1.6-cent spread. By definition the pilot will reduce the “true spread” to closer to one cent.
The question, given our recent post showing how many stocks already trade one cent wide is: Will that matter?
Our answer, based on observations in these charts is: Yes.
That’s because data here suggests V-shaped volume curves, so narrower “economic” spread should result in less depth at the new, narrower true NBBO. Although that might decrease costs for small takers, it will almost certainly reduce depth, and may even increase the cost of liquidity for larger traders. Chart 4 shows how.
- Based on our observed V-shaped volume curves, reducing the actual spread captured by liquidity providers from 1.6 cents to 1.0 cents should reduce depth by around 30%.
- After accounting for mid-point liquidity, that math says the old 1,000 share NBBO will fall to just 651 shares.
- Just like in Chart 1, a large trade that needs to buy 1,000 shares will now need to lift the near touch and part of the next level. In this simple example, the total cost of those 1,000 shares actually increases by 6% above the current cost of the take fees.
Chart 4: Estimating the cost of liquidity with a zero-rebate market vs. a rebate market
Click image to see full-size version
Source: Nasdaq Economic Research
There could be other unintended consequences too. A passive trader bidding for 500 shares will almost double the new book skew, which may make their trade easier to detect. In the short term that makes institutional trading more expensive. In the long term it probably makes it darker.
Then who will that leave with an economic incentive to post the one-cent wide lit quotes?
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Phil Mackintosh
Nasdaq
Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency.
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