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Asian Review of Financial Research Vol.22 No.2 pp.71-102
The Role of Market Depth in Determining Appropriate Tick Size in the Korea Exchange
Hyung Cheol Kang Assistant Professor, Department of Business Administration, University of Seoul
Jong-Ho Park* Professor, Department of Business Administration, Sunchon National University
Kyong Shik Eom UC Berkeley, Department of Economics, Research Fellow
Key Words : Tick Size,Liquidity,Market Depth,Market Quality,Panel-Data Analysis,Endogeneous Event Studies


To determine the appropriate tick size for the Korean Exchange (KRX), we analyze the effect of changing the minimum tick size (hereafter “tick size”) on, first, the liquidity, measured by relative spread, market depth, and volume and secondly, on the overall market quality. The results from these analyses shed light on the optimal tick size for the KRX. Our finding shows an ambiguous effect of changing the tick size on market quality: reducing the tick size increases relative spread and volume but decreases market depth. Also, compared to the U.S. exchanges whose tick size is one cent regardless of the stock price, the tick size of the KRX is a step function of the stock price. This characteristic allows us to study the effect of changing the tick size by comparing stocks with prices just above and just below the level at which the tick size changes. Unlike previous studies, our analyses focus on the effect of changing the tick size on market depth among liquidity variables, by, among others, addressing the endogeneity problem among the variables. Other specific methods used in our analyses are as follows. First, as a preliminary study, we examine whether our results regarding the effects of changing tick size on three variables of liquidity--relative spread, market depth, and volume--in the KRX are the same as those from previous studies on domestic and overseas exchanges. Second, we investigate the effects of changing tick size on investors' order submission patterns to find the reasons and implications of the adverse effects of reducing tick size on market depth. For both analyses, we conduct panel-data analyses, which are robust even with the endogeneity problem. Rogers' (1993) standard errors are incorporated in order to adjust for the clustering effect. Third, we test dynamic relations between tick size and market depth in order to obtain detailed results indicating the effects of reducing tick size on market depth. This test is designed to measure the extent to which the KRX tick size could be reduced. For this test, we use the sample stocks whose tick sizes change during the sample period. We, first, sort them into 9 categories based on their upper and lower price limits and, then, conduct “endogeneous” event studies. Using all 689 common stocks listed on the KRX during our sample period of 122 trading days from January 3 to June 30 in 2005, we apply both TAQ (Trades and Quotes) and daily data to each stock. The data are provided by the KRX. The test results for our seven null hypotheses are as follows. •Results from Analyses for the Effects of Changing Tick Size on Liquidity: Reducing tick size has a favorable effect on relative spread and volume, but an unfavorable effect on market depth. This finding of trade-off among the liquidity variables confirms similar results from previous studies; however our finding is more robust, since the endogeneity problem among the variables is taken into account in the regression analyses. Our study also has the practical implication that policy makers must heed unfavorable effect on market depth when considering reducing the tick size as a way to reduce transaction costs. •Results from Analyses Using Investors' Order Submission Patterns: As tick size is reduced, order size decreases and the ratio of cancellation and correction orders increases. Market depth, in turn, is decreased and market quality deteriorates. As tick size is reduced, the ratio of “order-more-improved to best-order” also increases. This increase leads market depth and relative spread to decrease; as a result, it can either improve or deteriorate market quality due to the trade-off between them. As tick size is reduced, the market-order ratio slightly increases, decreasing liquidity and, in turn, resulting in a slight deterioration of market quality. All together, a decrease in order size and an increase in the ratio of cancellation and correction orders are, at least, principal causes for decreasing market depth as tick size reduces. •Results from Dynamic Relation between Tick Size and Market Depth: Reducing tick size does not decrease the market depths of the stocks whose prices are around the points at which the tick size jumps, except at 10,000 won. This implies that the tick size can be reduced at most price levels without deterioration of market depth. The price range jumping around 10,000 won is the only exception at which market depth decreases with statistical significance as the tick size decreases. This phenomenon is closely related to the large change in the relative tick size (from 0.1% to 0.5%) at this price range, which is a very abrupt change compared to that at other price ranges (from 0.1% to 0.2%, in particular for 5,000 won and 50,000 won price ranges). Therefore, if we set our argument to stocks under 100,000 won, the KRX can reduce the relative tick size 0.2 percent without having significant adverse effects on market depth.
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