Effect of Decimalization on Market Equilibrium and Price Discovery

Abstract

Recent crises have focused interest on methods to improve the functioning of financial markets. In this context it would be prudent to evaluate the effects of previous changes. Previous research on decimalization of tick size, a significant microstructure change, mostly examines its effects on spreads etc. This paper studies the effect of decimalization on the dynamics of market equilibrium in fragmented markets, when a single or identical assets are traded in several markets. Using cointegration analysis this study finds that when a price innovation enters one market, the time taken for new equilibrium to be reached by other markets is significantly longer after decimalization. This finding is important in the context of the current market environment of Direct Market Access (DMA). When markets are in disequilibrium even for a few additional micro seconds, high frequency trading algorithms can provide a trading advantage, and create new arbitrage opportunities.