Agent trading models, speed and market making incentives

This study analysed the effect of the tick size pilot program implemented by the United States Securities and Exchange Commission on the trading behaviour of three market participant groups: proprietary trading companies, banks and agency firms. The purpose of the study was to provide an in-depth analysis of how the tick size pilot program affected those three groups, in order to infer the competitive advantages and liquidity preferences of each market participant category. First, this dissertation examined the effect of the policy change on market participants’ competition for order flow, liquidity provision and transaction costs. The empirical findings indicated that the program encouraged proprietary trading companies to increase their liquidity provision, induced banks to cross the spread more often and move their order flow from BX to Nasdaq and increased agency firms’ waiting costs. Second, the effect of the policy change on market participants’ intraday order submission strategies and ability to establish time priority was examined. The current literature suggests that tick size consolidations exacerbate the need for speed and allow proprietary trading companies to extract rents from other traders by establishing time priority. Conversely, this study’s empirical findings indicated that banks are as fast as proprietary trading companies but cross the spread more frequently to ensure full execution of their clients’ orders. Thus, differences in business models seem to be more important compared to speed in explaining the trading strategies of banks and proprietary trading companies. Finally, the study examined the effects of policy change on two groups of proprietary trading companies: (i) those specialised in using opportunistically marketable orders and (ii) market makers. The results indicated that opportunistic traders were specialised in predicting short-term price movement and minimising adverse selection risk, while market makers were specialised in establishing time priority to capture the bid–ask quoted spread as much as possible. Nevertheless, both classes of proprietary traders increased their liquidity provision and trading revenues on treatment stocks by leveraging their specific competitive advantages.