Academic journal article Quarterly Journal of Business and Economics

Did Decimalization Benefit Members of the Toronto Stock Exchange?

Academic journal article Quarterly Journal of Business and Economics

Did Decimalization Benefit Members of the Toronto Stock Exchange?

Article excerpt

Introduction

The decimalization of the North American market has attracted considerable research interest among academics, exchanges, and the regulatory body. (1) Large numbers of studies look into the effects of decimalization on the trading environments, such as bid-ask spreads, depth, trading volume, etc. These studies in general report reduced bid-ask spreads (quoted, effective, and realized), reduction in the quoted size, and lower return volatility. Although prior studies shed significant light on the effect of decimalization on trade costs, market quality, and inter-market comparison of trading cost, its effect on welfare of the exchange and market makers has received little attention. Yet the welfare of the exchange and its members is one of the key issues that policy makers had in mind, as indicated in the following press release of the Toronto Stock Exchange (TSX):

   We believe that trading in decimal increments will help secure
   our competitive advantage in the global marketplace...... This
   will benefit all investors in our market. The Exchange and its
   members will also benefit. (italics added) (2)

In this paper, we contribute to the literature by providing evidence on the effect of decimalization on the welfare of market makers. Using the first decimalization in the North American market, i.e., the TSX decimalization, we examine whether decimalization has delivered the intended benefits to TSX members. In particular, we examine changes in TSX seat prices and changes in the TSX's total trading volume and market share for stocks that are simultaneously interlisted on the TSX and a major U.S. market. A distinctive feature of our study is our focus on TSX seat prices in a multivariate framework to determine whether decimalization has increased the value of membership at the TSX. To the best of our knowledge, our work is unique in examining the effect of the decimalization on TSX members' welfare by looking at changes in seat prices.

We first document a significant reduction both in the bid-ask spread and the quoted depth following the switch to decimal quotes. These results are consistent with the predictions in Harris (1994, 1997, and 1999) and overlap with the evidence in several existing studies on TSX decimalization. (3) We present these results primarily to set the stage for our discussion on the main issues in this paper: analysis of the TSX trading volume, market share, and seat prices.

We then look at the impact of decimalization on trading volume and the TSX market share of total trading volume of interlisted stocks. (4) We find no significant changes in both trading volume at the TSX and the TSX market share of the total interlisted trading volume following decimalization. We also do not find, on average, any significant changes in spreads and depths of the interlisted stocks traded on US markets.

The evidence of lower bid-ask spreads, no significant changes in trading volume, and TSX's market share appears to suggest that TSX members' profits may have suffered as a result of decimalization. In order to determine whether decimalization has increased or decreased the welfare of the TSX members, we examine prices from seat sales at the TSX.

If interlisted order flow or domestic trading volume increases or both order flow and trading volume increase, then TSX members are expected to benefit from increased market making and agency revenues. On the other hand, a reduction in the tick size can result in a transfer of wealth from TSX market makers to traders, leaving the net impact on TSX membership an unsettled issue.

The effect of decimalization on market makers' welfare is an unsettled issue in the literature. Existing studies of the TSX decimalization (Ahn, Cao, and Choe, 1997; Bacidore, 1997; and Weaver and Porter, 1997 (5)) report a significant decrease in the quoted spreads of 17 to 27 percent and in the quoted depth of 27 to 52 percent, and no statistically significant increase in trading volume. …

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