Journal of Banking and Finance 85 (2017) 69–82

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Journal of Banking and Finance

journal homepage: www.elsevier.com/locate/jbf

Human vs. high-frequency traders, penny jumping, and tick size

Soheil Mahmoodzadeh a, Ramazan Gençay b,∗
a
Faculty of Economics, University of Cambridge, Sidgwick Avenue, Cambridge CB3 9DD, United Kingdom
b
Department of Economics, Simon Fraser University, Burnaby, BC, V5A 1S6, Canada

a r t i c l e i n f o a b s t r a c t

Article history: This paper examines changes in market quality resulting from the smaller tick size of the interbank for-
Received 1 July 2015 eign exchange market. Coupled with the lower tick size, the special composition of traders and their or-
Accepted 20 August 2017
der placement strategies created a suitable environment for high-frequency traders (HFT’s) to implement
Available online 31 August 2017
sub-penny jumping strategy to front-run human traders. We show that the spread declined following the
JEL Classification: introduction of decimal pip pricing. However, benefits of spread reduction were mostly absorbed by the
F31 HFT’s. Market depths were also significantly reduced with the occupation of the top of the order book
G14 by HFT’s. This new environment changed the market maker-market taker composition between different
G15 traders and altered price impacts of the order flows.
Keywords: © 2017 Elsevier B.V. All rights reserved.
Interbank foreign exchange market
Tick size
Market quality

1. Introduction
In this paper, we study changes in Electronic Broking Services
(EBS) market quality following the adoption of the decimal pip
tick size. EBS is the leading interbank foreign exchange (FX) mar-
ket, and it is mainly used to trade major currency pairs (EUR/USD,
USD/JPY, EUR/JPY, USD/CHF, and EUR/CHF) in units of millions. We
show how the specific structure of the EBS market has helped
HFT’s sub-penny jump human traders to take advantage of the
lower tick size.1
Sub-penny jumping is a front-running strategy in which the
sub-penny jumper trades in front of and on the same side of a
slower, patient trader by improving the price by the smallest pos-
sible amount (tick size). In equity markets, exchanges are forbid-
den from accepting, ranking or displaying orders in price incre-
ments of less than a penny. However, sub-penny trading is al-
lowed when trade is executed through Alternative Trading Sys-
tems such as dark pools or is internalized by broker-dealers. Penny
jumping has been investigated in the equity markets. For exam-
∗
Corresponding author.
E-mail addresses: soheil.mz@gmail.com (S. Mahmoodzadeh), rgencay@sfu.ca (R.
Gençay).
1 more liquid pairs. Empirical studies on stock exchanges gener-
For an overview of the literature on HFT, see surveys conducted by
Jones (2013) and O’Hara (2015). While some studies have supported the beneficial
role of HFT (see among others, Hendershott et al. (2011), Hasbrouck and Saar (2013),
Brogaard et al. (2014), and Chaboud et al. (2014)), other studies have highlighted
its harmful effects (see for example Hirschey (2013), Biais and Woolley (2011), and
Kirilenko et al. (2015)).
ple, Ready (1999) presents empirical evidence that dealers on the
NYSE impose adverse selection costs on standing limit orders by
selectively stepping ahead of these orders to interact with incom-
ing marketable orders. Bourghelle and Declerck (2004) show that a
relatively larger tick size encourages traders to submit and expose
limit orders, while a smaller tick size induces frequent undercut-
ting strategies.
There has been much debate regarding the effects of tick size
on financial markets. Recently, in June 2014, the Securities and
Exchange Commission (SEC) ordered a plan to implement a tar-
geted one year pilot program that will widen the tick size for
certain small capitalization stocks to assess effects on market
quality. The effects of tick size changes have motivated theoret-
ical studies on suitable minimum tick size selection. These in-
clude, among others, Harris (1994), Anshuman and Kalay (1998),
Cordella and Foucault (1999), Alexander and Zabotina (2005),
Kadan (2006), and Ascioglu et al. (2010). In the theoretical
and empirical literature on tick size in equity markets, there
is also a debate regarding whether the effects of tick size re-
duction may depend on the liquidity of a stock (see, for ex-
ample, Bourghelle and Declerck (2004) and Goldstein and Kava-
jecz (20 0 0)). Similar considerations also apply for interbank for-
eign exchange markets, wherein tick sizes are always smaller for
ally show that tick size reduction is associated with a decline
in both the spread and depth (see, among others, Goldstein and
Kavajecz (20 0 0), Bessembinder (20 0 0), Jones and Lipson (20 01),
Bacidore et al. (2003), Bessembinder (2003) and Ahn et al. (2007)).

http://dx.doi.org/10.1016/j.jbankfin.2017.08.015
0378-4266/© 2017 Elsevier B.V. All rights reserved.
70 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82
Only a few papers have examined the effects of tick size
on the interbank FX market. Using proprietary data from EBS,
Schmidt (2012) shows that human traders do not use the last digit
very often under decimal pip pricing conditions. He also provides
a taxonomy of types of EBS customers and of their order place-
ment characteristics. Lallouache and Abergel (2014) analyze EBS
data, EUR/USD and USD/JPY distributions and report price cluster-
ing for prices ending in “0” and “5” after March 2011. They argue
that automated traders take price priority by submitting limit or-
ders one tick ahead of clusters. However, they do not provide in-
sight into why these traders take such priority. The observation
that emerges from these two papers is that the EBS market mi-
crostructure changed significantly after the introduction of decimal
pip pricing. In analyzing the EBS market before and after the intro-
duction of decimal pip pricing, our findings indicate that:
• Our results show that HFT’s use sub-penny jumping against
slower traders.
• The spread as a measure of liquidity cost decreased following
the introduction of decimal pip pricing. However, we argue that
due to the implementation of the sub-penny jumping strategy,
benefits of the reduction in spread were mostly absorbed by
HFT’s.
• The absolute value of the realized spread also decreased toward
zero meaning that the market maker should suffer less adverse
price moves.
• HFT’s, in using the sub-penny jumping strategy, occupied the
top of the order book with smaller orders, leading to a signifi-
cant drop in market depth.
• The tick size change also changed the market maker-market
taker composition of human and algorithmic traders in the EBS
market. While the share of the computer maker-computer taker
from total trades increased, the share of human maker-human
taker decreased after the tick size change.
• The new environment also altered the relationship between re-
turns and order flows measured by the price impact regression.
The remainder of the paper is organized as follows.
Section 2 describes the datasets that we use, presents tick
size changes in the EBS market, and describes the structure of
the EBS market. Section 3 describes sub-penny jumping and
Section 4 provides empirical evidence for the existence of sub-
penny jumping, and discusses the effects of tick size changes on
interbank FX market quality. Section 5 concludes.
2. Data and institutional background
2.1. Data description
Banks and large financial institutions trade currencies with one
another on two interbank electronic trading platforms: EBS and
Reuters. EBS is the leading liquidity provider for EUR/USD, USD/JPY,
EUR/JPY, USD/CHF and EUR/CHF, and Reuters is the primary trad-
ing venue for commonwealth and emerging market currencies. To
study the effects of tick size changes on interbank FX market, we
use four EBS data sets as described below:
EBS level 1, 2004–2008. These data include one level quote (best
buy and sell) and deal records at a one second frequency.2 The
data were used to find the minimum tick sizes of the EBS market
for January 2004 to December 2008.
EBS level 10, 2009–2011. These data include ten level quotes
and deal records of a 100 millisecond frequency. They were
2 4
“Deal” is a term used by EBS. It is synonymous with trade.
used to find the tick sizes of the EBS market for January
2009 to December 2011. Important tick size changes were im-
plemented in March 2011 and the data covers this period. We
used these data to analyze different levels of the limit order
book (LOB) and in our analysis related to pip and decimal pip
tick sizes.
EBS level 10, 2013. These data include ten level quotes and deal
records of a 100 millisecond frequency for January to February
2013. We obtained tick size changes for 2012 from EBS. Tick sizes
for January to February 2013 are consistent with EBS 2012 infor-
mation.
From the three datasets above, the dealt prices are the high-
est buying or lowest selling deal prices between two consecu-
tive snapshots of the LOB rounded to seconds or to 100 mil-
liseconds. The datasets do not include dealer identifications and
there are no hidden orders. In EBS terminology, EUR/USD de-
notes the amount of local currency (USD) needed to buy (or
sell) one unit of the base currency (EUR). Orders are sub-
mitted in units of millions of the base currency.3 We ex-
cluded thin weekend trading periods and holidays because liq-
uidity during these periods may have been extremely limited.
We also controlled for daylight savings and standard time. Sim-
ilar conventions were adopted by Andersen et al. (2003) and
Chaboud et al. (2004).
EBS Maker-Taker, 2011. These transaction data provide the minute-
by-minute last price, aggregated volume, and direction of trade
broken down into human (H) and computer (C) traders for January
to June 2011. It provides eight types of human and computer mak-
ers and takers (HHb , HHs , HCb , HCs , CHb , CHs , CCb , and CCs ) where
b denotes buyer-initiated trade and where s denotes seller-initiated
trade. The market maker posts quotes before the market taker (ini-
tiator) chooses to trade at the quoted price. The sum of buyer
and seller initiated volumes provides volumes attributable to the
human maker-human taker HH, computer maker-human taker CH,
human maker-computer taker HC, and computer maker-computer
taker CC. The difference between buyer and seller initiated vol-
umes is the order flow.
2.2. Minimum tick size
In March 2011, EBS decided to reduce the tick size (minimum
price movement) for major currency pairs from a pip (four dec-
imals) to a decimal pip (five decimals). For example, when the
tick size is a pip equal to 0.0 0 01 and the EUR/USD best bid is
1.39940, then a buyer can improve this price by placing an or-
der at a price of 1.39950. However, when the tick size is a deci-
mal pip equal to 0.0 0 0 01, the buyer can also place an order at a
price of 1.39941. Reuters, the main competitor to EBS, still uses pip
pricing. Tick sizes considerably affect liquidity provision and trans-
action costs. A large tick size increases trading costs by widening
the spread. A liquidity effect arises when a small tick size makes
it easier for traders to step ahead of an existing limit order, in-
creasing the cost for traders who provide liquidity. It is a challenge
for markets to choose an optimal tick size to balance liquidity and
transaction cost effects. We analyzed our datasets to find EBS tick
size changes for 2004 to 2013. Fig. 1 illustrates tick size changes
in the EBS market.4 For instance, the tick size was a pip (4 deci-
mal points) for EUR/USD until March 2011. It was then reduced to
a decimal pip (5 decimal points). Finally, it changed to a half pip
3
EBS introduced small currencies in increments of 10 0,0 0 0 units of the base cur-
rency in 2010. The trading volume in small currencies is very minimal. Therefore,
we do not analyze such currencies.
We excluded currency pairs with minimal activities.
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82 71

Fig. 1. EBS Minimum Tick Size Changes, 2004–2013 Notes: Fig. 1 illustrates tick size changes in the EBS market occurring from 2004 to 2013 for different currency pairs.
The vertical axis shows decimal points used in the exchange rates. As an example, the EUR/USD tick size was 0.0 0 01 (one pip) until March 2011. Thus, if the best bid was
1.39940, then a trader could have improved this price by adding the tick size and placing an order at a price of 1.39950. However, the trader would not have been able to
place an order at a price of 1.39941 because the added value of 0.0 0 0 01 (a decimal pip) was less than the tick size of 0.0 0 01. The pip (decimal pip) tick size is 2 (3) decimal
points when the local currency is JPY, as the exchange rates are based on 100 JPY. The 2.5 and 4.5 decimal points refer to half pip pricing, which reflects a special case of
decimal pip pricing whereby the last digit can only be “0” or “5”. For example, a tick size of 4.5 for the EUR/USD exchange rate denotes that the tick size is one decimal pip
(5 decimal points) and thus that the fifth digit can only be “0” or “5”.

(4.5) in September 2012. Half pip pricing constitutes a special case
of decimal pip pricing whereby the fifth digit can only be “0” or
“5”.5 Fig. 1 shows this shift from pip pricing to decimal pip pric-
ing and, half pip pricing over a two-year period. The original shift
from pip to decimal pip pricing on EBS began in September 2010
with less active currency pairs, presumably to test the responses of
market participants. In October 2010, EBS reduced the tick size for
the next group of most commonly traded currency pairs: EUR/GBP,
GBP/USD, and USD/CAD. Finally, EBS reduced the tick size for the
five main currency pairs (EUR/USD, USD/JPY, EUR/JPY, USD/CHF and
EUR/CHF) to decimal pip in March 2011. The tick size was low-
ered to match smaller trading platforms to attract more HFT’s in a
competitive market. This move spurred intense debate between the
two main types of traders. Although decimal pip pricing was wel-
comed by HFT’s, human traders believed that HFT’s already had
an unfair advantage that had been enhanced by the smaller tick
size.6 After EBS shifted to decimal pip pricing, it eventually real-
ized in continuing to use decimal pip pricing, it risked losing more
business. This initiated a reversion to half pip pricing for most cur-
rency pairs in September 2012. Table 1 presents the dates of tick
size changes made in the EBS market.
2.3. Institutional background
In the following section, we provide information on the struc-
ture of the EBS market to help explain how with the lower min-
imum tick size, the structure of the interbank FX market caused
HFT’s to take advantage of human traders. Our analysis is based
on the EUR/USD currency pair. The other major currency pairs
(USD/JPY, USD/CHF, EUR/CHF, and EUR/JPY) are largely similar to
EUR/USD.7
There are two main types of traders in the EBS market: “auto-
mated” traders, who use an automated interface (AI) to place or-
ders without human intervention; and “human” traders, who use
GUI-based access for order management purposes. Human traders
are individuals who trade at the trading desks of major banks us-
ing keyboard. Unlike in the equity market, these traditional traders
play a vital role in the interbank FX market in terms of provid-
ing liquidity. The central role of human traders distinguishes the
structures of the interbank FX market from those of other mar-
kets. Human traders were either market takers or market mak-
ers in approximately 65% of EUR/USD transactions in 2011.8 Al-
gorithmic trading started in the EBS market in January 2004 .

5 7
The pip (decimal pip) tick size is 2 (3) decimal points when the local currency The full results for USD/JPY, USD/CHF, EUR/CHF, and EUR/JPY are available upon
is JPY, as currencies are traded against 100 JPY. request.
6 8
For example, see pages 14–15 of the report published by the Bank of Interna- The market maker provides liquidity by posting quotes and the market taker
tional Settlements (BIS): http://www.bis.org/publ/mktc05.pdf. trades at the quoted price.
72 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

Table 1
EBS Minimum Tick Size Changes, 2004–2013.

2010/08/30 2010/10/10 2011/03/07 2012/09/17 2012/11/25

EUR/GBP hp → dp dp → hp
AUD/USD p → dp dp → hp
EUR/AUD p → dp dp → hp
EUR/CAD p → dp dp → hp
NZD/USD p → dp dp → hp
USD/SGD p → dp
EUR/CHF p → dp dp → hp
EUR/USD p → dp dp → hp
USD/CHF p → dp dp → hp
AUD/JPY p → dp dp → hp
CAD/JPY p → dp dp → hp
CHF/JPY p → dp dp → hp
EUR/JPY p → dp
USD/JPY p → dp
GBP/USD p → dp dp → hp
USD/CAD p → dp dp → hp

Notes: Table 1 provides the tick size changes on EBS for 2004 to 2013, p denotes pip, dp
denotes decimal pip, and hp denotes half pip.

Participation has grown steadily and reached 20% by the end of

2005 and approximately 60% by the end of 2007. In 2011, com-
puter traders were either market takers or market makers of
EUR/USD transactions for approximately 85% of all trades. (see
Chaboud et al. (2014) and Schmidt (2012)). The main feature of
an AI in the EBS market is the presence of a professional trading
community (PTC) that places orders at very high frequencies.9
Using propriety data, Schmidt (2012) provides information re-
garding the ecology of the EBS market in 2011. The PTC typically
uses an order size of one million and almost never uses an order
size that exceeds four million. Human traders place larger orders
(approximately 5% of orders submitted by human traders have an
order size of ten million). The fill ratio is defined as the ratio of
dealt quotes to submitted quotes. This ratio is more than 50% for
human traders and is approximately 8% for the PTC. The high fill
ratio for human traders implies that these traders do not typically Fig. 2. EUR-USD, Last Digit Distribution, Pip Tick Size.
cancel their orders. Human traders did not widely use decimal pip
pricing following the tick size change. Approximately 80% of the
human traders used decimal pip pricing for less than 20% of their
orders. In contrast, AI traders widely adopted decimal pip pricing
in their quoted prices.10
In summary, human traders (slow traders), place larger orders
at prices ending in “0” (under pip pricing) and do not typically
cancel half of their orders. Human traders were reluctant to use
decimal pip pricing for a number of reasons. Prior to March 2011,
the value of a tick size was $100 for an order size of one million
under pip pricing. This value fell to $10 under decimal pip pricing
conditions. Furthermore, traditional human traders had grown ac-
customed to pip pricing over several years and found it difficult
to adapt to decimal pip pricing conditions. Human traders who
did not use decimal pip pricing and who used “0” as the fifth
digit created a price clustering at zero after the tick size change.
Figs. 2 and 3 present the distributions of the last digits of prices for
pip and decimal pip pricing conditions. The last digit distribution Fig. 3. EUR-USD, Last Digit Distribution, Decimal Pip Tick Size Notes: Figs. 2 and
3 show limit order book prices’ last digit distributions under pip and decimal pip
is nearly uniform under pip pricing conditions, but there is price
pricing in the EBS market. This distribution was nearly uniform under pip pricing,
clustering at zero under decimal pip pricing. Weaker price cluster- implying that traders used all digits equally for the last digit of prices. However, hu-
ing is also found for prices ending in “5”, potentially because some man traders did not use the last digit under decimal pip pricing, which means they
human traders used “5” to partially adapt to decimal pip pricing often used “0” for the fifth digit. This behavior created price clustering at prices
ending in zero.

9
Automated Traders are further divided into three subgroups: Professional Trad-
ing Community (PTC), Bank AI, and Aggregators. PTCs are high-frequency market conditions. If human traders typically used zero for the last digit
makers typically participating in the market by prime brokerage. Bank AIs are the
and placed larger orders, the volume distributions of prices ending
algorithmic trading operations of banks. Aggregators consolidate liquidity from mul-
tiple retail liquidity providers. in zero and non-zero digits should also have differed.
10
Order sizes, fill ratios, and last digits are shown in Fig. 1, Fig. 2, and Table 4 of Figs. 4 and 5 show that orders with prices ending in non-
Schmidt (2012). zero digits come in smaller volumes whereas orders with prices
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82
Fig. 4. EUR-USD, Volume Distribution, Decimal Pip, Last Digit=0.
Fig. 5. EUR-USD, Volume Distribution, Decimal Pip, Last Digit = 0 Notes: Because
human traders usually use zero for the last digit and place large orders, volume
distributions for prices ending in zero and non-zero digits differ in the EBS market.
Figs. 4 and 5 show that prices ending in non-zero digits are found in smaller vol-
umes, whereas orders with prices ending in zero are found in larger volumes. This
pattern indicates that human traders usually place larger orders at prices ending in
zero.
ending in zero come in larger volumes. A human trader who uti-
lizes a price ending in “0” and who trades in larger volumes is
a patient market maker given his high fill ratio. The described
structure of the EBS market creates an ideal HFT setting for front-
running human traders, using the sub-penny jumping strategy.
This is discussed in detail in the following section. While sub-
penny jumping is not the only strategy used by HFT’s to front-
run other traders, the particular order management strategy used
by human traders greatly facilitates the application of sub-penny
jumping by HFT’s.
3. Sub-Penny jumping
Human traders are slow traders. They submit larger orders at
prices ending in zero under decimal pip pricing, and do not cancel
their orders very often. In this section, we explain how HFT’s use
such information to implement sub-penny jumping strategies to
exploit a smaller tick size. Fig. 6 depicts potential patterns of sub-
penny jumping in the EBS market. Assume that a human trader
places a 9 million buy order for EUR/USD at a round price of
1.39940. A sub-penny jumper who can place an order at a very
high frequency, would then place a small order such as a 2 million
buy limit at 1.39941. The difference between this price and the hu-
man trader’s price is equal to the tick size, i.e., a decimal pip. Prior
to March 2011, the minimum cost for unwinding against a standing
one million limit order was $100 and fell to $10 thereafter. If the
73
sub-penny jumper buys at his placed order, he will move to the
sell side and can place a sell order at 1.39945. Three outcomes can
then result. If another trader places a buy market order at 1.39945,
the sub-penny jumper’s profit is $80. If a 2 million buy limit or-
der comes in at a price of 1.39943 (which is higher than 1.39941),
the sub-penny jumper can cancel his order and place a sell market
order at 1.39943. If the sub-penny jumper is successful in selling
his share, then his profit is $40. However, if the sub-penny jumper
thinks that the market is drifting away from his position, he can
sell back to the human trader at a price of 1.39940, resulting in a
loss of $20. If there is competition between HFT’s to front-run hu-
man traders, this should limit potential profits. HFT’s also use other
order anticipation strategies. We show that HFT’s frequently use
the sub-penny jumping strategy under decimal pip pricing condi-
tions.
Let us now consider the general case of sub-penny jumping in
the interbank FX market. Suppose that a human trader and a sub-
penny jumper place buy orders at p and p + τ or sell orders at p
and p − τ where τ is the minimum tick size. When the sub-penny
jumper buys or sells his order, he will move to the other side of
the order book. If the human trader does not cancel or adjust the
order and if other traders do not fill the human trader’s order,
( p+τ ) −τ
then the loss is bounded at the rate of return, a = p−p+ τ = p+ τ
( p−τ ) τ for
for the buying sub-penny jumper and at b = − p−p− τ = − p−τ
the selling sub-penny jumper. However, if prices move in favor
of the sub-penny jumper, such a favorable price change would be
profitable. We discuss the case of a buying sub-penny jumper, as
the selling case is very similar. Suppose that the rate of return
has a standard normal distribution: x ∼ N(μ, σ 2 ). This is a sim-
ple reduced-form model and not the equilibrium model since the
distribution of the return on the foreign currency is assumed to
be exogenously given. This is a reasonable assumption given the
liquidity of FX markets and given that our analysis is empirical
rather than theoretical. Once the sub-penny jumper trades, the or-
ders he front-runs protect him from serious losses. If prices move
in his favor, the sub-penny jumper profits to the full extent of price
changes. The returns are unbounded above and limited below by
( p+τ ) −τ
a = p−p+ τ = p+ τ . If the minimum tick size decreases, then the
conditional expectation of returns increases and the conditional
variance of returns decreases.11
dE (x|x > a )
E (x|x > a ) > E (x ) and <0
dτ
dV ar (x|x > a )
V ar (x|x > a ) < V ar (x ) and >0
dτ
For a smaller tick size, the sub-penny jumper must improve
prices by a smaller price increment to trade ahead of the human
traders. Therefore, the tick size is the price that the sub-penny
jumper must pay to front-run the human traders. However, sub-
penny jumpers do not pay this price to the human traders; in-
stead, they pay it to the traders with whom they trade to es-
tablish their positions. These traders would have traded with the
human traders if the sub-penny jumper had not front-run them.
A sub-penny jumper will trade profitably only if the standing or-
ders that they front-run do not cancel the orders, adjusting them
quickly, and other traders do not fill the human trader’s order. If
these options are no longer available, the sub-penny jumper will
have difficulty when prices move against him. Based on the EBS
market structure presented in Section 2, HFT’s know that orders
with prices ending in zero and larger order sizes denote the pres-
ence of human traders to front-run. These orders are not canceled
or adjusted very often, and due to their larger volume, they can-
not be filled quickly. In general, HFT’s post inside quotes by front
11
We refer the reader to Appendix A for the proof.
74 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

Fig. 6. Sub-Penny Jumping, HT- HFT Notes: Fig. 6 provides an example of sub-penny jumping strategy implemented by HFT’s in the EBS market after the introduction of
decimal pip pricing. HT stands for human trader and HFT refers to the high-frequency trader.

running the best prices, and human traders post outside spreads.
Then, when the sub-penny jumper trades, if the market starts to
move against him, he trades with the human trader. This occurs
systematically in accordance with the order management strategy
employed by human traders, differentiating this market from the
equity market.
4. Sub-Penny jumping and market quality
In this section, we study LOB distributions and market
quality measures such as spread, realized spread and market
depth.12 The change in market maker-market taker composi-
tions has also changed permanent price impacts measured by
Hasbrouck (1991) VAR model.
12
We focus on the introduction of decimal pip pricing. All figures related to the
half pip can be found in the online appendix for this paper.
4.1. LOB Distributions
We study tick sizes in the EBS market across three periods. The
tick size was a pip until March 2011, when it was reduced to a dec-
imal pip. It was then changed to a half pip in September 2012. As
is shown in Fig. 7, distributions of orders’ last digits were almost
uniform with pip tick size for both the bid and ask sides. The x-
axis shows the last digits ranging from “0” to “9”. The y-axis shows
the limit order book level on a range of level “1” to level “10”. The
term “level” refers to occupied price levels, which implies that the
difference between two levels is not necessarily the minimum tick
size. For example if the best price is 1.3994 at the best buy (level
1), the next price (level 2) could be 1.3996 where the difference
is more than the minimum tick size. Frequency distributions are
given on the z-axis.
As human traders were reluctant to use decimal pip pricing,
we found a price clustering of quotes at all limit order book lev-
els for prices ending in zero. Furthermore, if a buying human
trader places an order with a price ending in “0” (e.g., 1.39940),
the buying sub-penny jumper who wants to front-run the human
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82 75

Fig. 7. EUR-USD, LOB Last Digit Distributions, Pip Tick Size Notes: The price’s last digit distributions were almost uniform in the EBS market for all levels of the bid and for
ask sides of the order book with pip tick size as is shown in Fig. 7.

Fig. 8. EUR-USD, LOB Last Digit Distributions, Decimal Pip Tick Size Notes: Fig. 8 illustrates the bid and ask price last digit distributions in the EBS market for the ten levels
of the limit order book with the decimal pip tick size.

trader should place an order with a price ending in “1” (1.39941).
If there are other sub-penny jumpers, they would place their or-
ders with prices ending in “2”, “3”, etc. However, greater distance
from “0” denotes lower expected profits; therefore, we anticipate a
decreasing distribution of the number of orders for the buy side
of the limit order book at all levels. Fig. 8 shows such distri-
butions for the ten levels of the order book with different last
digits. For example, for the level-one buy side of the limit order
book, 28% of all orders have a last digit of “0”, and 18% of the or-
ders have a last digit of “1”. This ratio begins to fall and reaches
2.5% for orders with a last digit of “9”. The shapes of the distri-
butions at other levels of the bid side are similar to the shape
at level-one.
If a sub-penny jumper improves upon the order of a human
trader by one tick while bidding, he would place an order with
a last digit of “1”. However, if an HFT improves on a human
trader’s price (e.g., 1.39940) on the ask side, he should place a
price ending in “9” (1.39939). Therefore, we would expect an in-
creasing distribution (excluding “0”) for all levels of the sell side
of the limit order book. For example, in Fig. 8, we see that ap-
76 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

Fig. 9. EUR-USD, LOB Volume Distributions, Pip Tick Size Notes: Fig. 9 illustrates order book volume distributions in the EBS market with pip tick size. The presence of
human traders at the top of the book generates larger volumes.

proximately 28% of the orders have a last digit of “0”, but only Table 2
Spread summary statistics.
approximately 2.7% of the orders have a last digit of “1”. This ra-
tio starts to rise and reaches 19.5% for orders with a last digit of Min Max Median Mean Std.dev
“9”. We observe the same distributions at other levels of the ask Pip (p) 0.0 0 010 0.00250 0.0 0 010 0.0 0 015 0.0 0 0 06
side. Distributions for decimal pip pricing also show lower levels Decimal Pip (dp) 0.0 0 0 01 0.0 040 0 0.0 0 012 0.0 0 013 0.0 0 0 07
of price clustering for prices ending in “5”. It appears that some
human traders placed such orders to adopt decimal pip pricing
without the complexities involved when using all of the digits. traders did not stop using larger orders. Patterns similar to those
However, the volume sizes used with this digit are smaller, and of the order books are found in the deal prices.13
there was no opportunity for HFT’s to front-run the digit “5”. The
different patterns on the ask and buy sides provide evidence of 4.2. Spread & realized spread
sub-penny jumping in the EBS market under decimal pip pricing
conditions. Spread, defined as the difference between best ask and best
Volume distributions also provide evidence of sub-penny jump- bidding prices, is a measure of liquidity cost. Table 2 provides sum-
ing. When HFT’s front-run human traders, they secure their po- mary statistics for spread under different tick size conditions. The
sitions by placing smaller orders. We know from Section 2 that average spread, which was 0.00015 under pip pricing conditions,
HFT’s typically use one million orders and almost never use an decreased to 0.00013 under decimal pip pricing.
order size exceeding four million. As a result, we should observe We test the following hypotheses on the spread mean based on
smaller volumes at the top of the order book under decimal pip different scenarios. All test are strongly rejected with all p-values
pricing conditions. The order book volume distributions under pip being less than 0.00001.
and decimal pip pricing are given in Figs. 9 and 10, respectively.  
At level one of the buy side under pip pricing, 16% of orders had H0 μdp ≥ μ p H0 μhp ≥ μ p
a size of one million, and 11% had a size of more than ten million. Ha μdp < μ p Ha μhp < μ p
However, under decimal pip pricing, 61% of orders had a size of
Fig. 11 indicates whether the spread was binding under pip and
one million, and only 0.7% of orders had a size of more than ten
decimal pip pricing.14 The results show that on average, the spread
million. Changes observed at the other levels are more significant.
was binding (equal to 0.0001) more than 50% of the time under pip
At level two with pip pricing, 3% of orders had a size of one mil-
pricing. This means that there was pressure on the spread to de-
lion, and 44% had a size of more than ten million. However, under
crease, which could partially justify the adoption of decimal pip
decimal pip pricing, 62% of orders had a size of one million, and
tick size. Fig. 11 also shows that approximately 1% of the time,
only 1% of orders had a size of more than ten million. Changes ob-
the spread was binding and equal to 0.00001 under decimal pip
served on the sell side of the order book are similar to those on
pricing. This suggests that the decimal pip tick size was small for
the bid side.
EUR/USD in the EBS market. Fig. 12 shows the one-hour aver-
When comparing Figs. 9 and 10, we find that large volumes
age spread for 2011. In the graph, each dot represents a one-hour
nearly disappeared from the top of the order book. Along with
other processes, some human traders may use smaller orders with
13
decimal pip pricing, which could partially explain the change ob- To avoid repeating similar results, we have provided all the results related to
served in the order book. However, according to Section 2, human the deals in the online appendix of this paper.
14
If the tick size is τ and the spread is equal to τ , spread is binding.
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82
Fig. 10. EUR-USD, LOB Volume Distributions, Decimal Pip Tick Size Notes: The order book volume distributions in the EBS market with decimal pip tick size are given
in Fig. 10. HFT’s have occupied the top of the order book by smaller volumes.
Fig. 11. EUR-USD Binding Spread, Pip & Decimal Pip. Notes: Fig. 11 illustrates the
binding EUR/USD spread under pip and decimal pip tick sizes in the EBS market.
The dashed line indicates the time of the tick size change in March 2011.
Fig. 12. EUR-USD Spread, Pip & Decimal Pip Tick Size Notes: Fig. 12 illustrates the
one-hour frequency EUR/USD spread under pip and decimal pip tick sizes for 2011.
77
average spread, depict all 24 observations (hours) across the day.
The gaps represent weekends which we have excluded. When EBS
changed the tick size from pip to decimal pip in March 2011 as
denoted by the dashed line in the graph, there was a significant
draw down in the spread. Technically speaking, traders were given
more options inside the spread, which was subjected to greater
pressures before.
To test the effects of the lower tick size on the spread, we use a
difference-in-difference (DID) estimation. The DID is typically used
to identify the effects of a specific policy intervention or treatment.
The premise of the DID approach is that when an intervention has
an effect, the difference between the unaffected group (the con-
trol group) and the group directly affected by the intervention (the
treatment group) should change after policy intervention. Then,
one compares the difference in outcomes between the two groups
before and after the intervention. We selected EUR/USD as a treat-
ment group to test our hypothesis. The best control group would
be the same currency pair in the Reuters market on the condition
that the spread in Reuters was not affected by the tick size change
in the EBS market. Unfortunately, we do not have access to these
data. As the next best options, we used the next most commonly
traded currency pairs in the EBS market: EUR/GBP, AUD/USD and
GBP/USD. The tick size did not change for these currency pairs
in the time period under consideration. The control groups are
not perfect since these currency pairs are primarily traded under
Reuters and thus may have low liquidity for EBS. We could not
study changes in the spread from decimal pip to half pip condi-
tions because as is shown in Fig. 1, EBS simultaneously changed
the tick size for the treatment and control groups. We considered
other factors that may have changed during and around March
2011 that may have impacted our analysis, including changes in
the tick sizes of other venues. Furthermore, If the HFT’s shifted ac-
tivities from the control groups to the treatment groups, the con-
trol groups would have been indirectly affected by the tick size
change. We did not find significant changes in deals and states of
the limit order book of the control groups.
78 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

Table 3
Conditional mean estimates from the DID regression model.

After Tick Size Change Before Tick Size Change Difference

Treatment β0 + β1 + β2 + β3 β0 + β2 β1 + β3
Control β0 + β1 β0 β1
Difference β2 + β3 β2 β3

Assuming that the treatment effect is stationary over time, we

define the DID model as:
St = β0 + β1 P + β2 T + β3 P T + εt (1)
where T is a treatment variable equal to one for EUR/USD and
equal to zero for the control group; P is the post-treatment in-
dicator, equal to one after the tick size change and equal to zero
before the change. T controls for permanent differences between Fig. 13. EUR-USD Realized Spread, Pip & Decimal Pip. Notes: Fig. 13 indicates the
the treatment and control groups, with β 2 capturing this varia- one hour realized spread average under pip and decimal pip pricing in the EBS
tion. Similarly, P controls for trends common to both the control market in 2011.

and treatment groups, and β 1 captures this variation. The variation

that remains is captured by β 3 . Conditional means corresponding
to the four combinations of T and P produce Table 3.
The DID regression results for the one-hour EUR/USD average
spread for different control groups are provided in Table 4. In all
cases, the estimates of β 3 are negative and significant at the one
percent level. We also used the one-minute average spread fre-
quency in our robustness checks. The results, which are presented
in Table 4, show that the estimates of β 3 are significant at the one
percent level. The estimates are close to the difference between
the average spread, with the pip and decimal pip being equal to
-0.00002. The DID regression results indicate that the spread de-
creased after the tick size changed due to the lower minimum tick
size. A reduction in the minimum tick size from pip to decimal pip
enables HFT’s to post more aggressively priced limit orders in the
EBS market, leading to tighter quoted spreads. However, by reduc-
ing the cost of implementing sub-penny jumping strategies, HFT’s
occupied the top of the order book, and benefits of the reduction
in the spread were mostly absorbed by them. We then estimate
the realized spread defined as:
RSt = 2qt ( pt − mt+s )
where pt is the deal price at time t, mt+s is the midpoint at time
t + s and qt is the trade indicator equal to 1 for buyer-initiated
trade and -1 for seller-initiated trade. We selected the s = 5 sec-
ond window for the midpoint.
In the case of buyer-initiated trade, a positive realized spread
means that the market maker can unwind his short position to
make a profit. A negative realized spread means that he has suf-
fered an adverse price move and must revise his estimate of the
fundamental value accordingly. Similar reasoning applies to seller-
initiated trade. The absolute value of the realized spread has de-
creased toward zero, meaning that the market maker should suffer
less from adverse price moves. Fig. 13 presents the realized spread
under pip and decimal pip pricing for 2011. The graph shows the
one-hour average realized spread of EUR/USD exchange rates.
Notes: To test the effects of the lower tick size on the spread,
We define the DID model by:
St = β0 + β1 P + β2 T + β3 P T + εt
where T is a treatment variable equal to one for EUR/USD and
equal to zero for the control group; P is the post-treatment indi-
cator, which is equal to one after the tick size change and equal
to zero before the change. β 2 captures permanent differences be-
tween the treatment and control groups. Similarly, β 1 captures
trends common to both the control and treatment groups. The
variation that remains is captured by β 3 . Table 4 provides the
difference-in-difference estimation results for the EUR/USD spread
Fig. 14. EUR-USD Market Depth, Pip & Decimal Pip Notes: Fig. 14 shows EUR/USD
daily average buy side depth under pip and decimal pip pricing in 2011. Each circle
shows which order size is necessary to move the best price by 0.0001, and each
triangle shows a market depth of 0.0002.
(2) average. We have used EUR/GBP, AUD/USD and GBP/USD as control
groups because they are the busiest currency pairs after the major
currency pairs. Panels A and B provide the results for one hour and
one minute frequencies, respectively. The estimates of β 3 are neg-
ative and significant at the one percent level, indicating that the
spread decreased following the introduction of decimal pip pric-
ing.
4.3. Market depth
Market depth is the amount available in the limit order book.
This quantity could also be interpreted as the size an order must
reach to move the market’s best available price by a given amount.
Generally, traders prefer deep markets because they can better ab-
sorb price impacts. In analyzing both bid and ask sides of the
market, we have calculated EUR/USD market depths of 0.0001 and
0.0002 under pip and decimal pip conditions. This shows how
much volume is available between the best bid, or sell, and the
(3)
next price with 0.0001 and 0.0002 differences. Fig. 14 shows the
daily averages of ask side depth. As is done above, the dashed
line indicates the tick size change from pip to decimal pip condi-
tions occurring in March 2011. Each circle denotes a market depth
of 0.0001, and each triangle shows a market depth of 0.0002. For
example, orders of $15-$20 million were necessary to move the
best bid by 0.0001 under pip pricing prior to March 2011. How-
ever, an overall order size of $10-$15 million was sufficient to move
the best price by the same amount following the introduction of
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82 79

Table 4
Difference-in-difference regressions of EUR-USD spread.

Panel A: One Hour Frequency

Control Group EUR-GBP (T=4,236) AUD-USD (T=4,012) GBP-USD (T=3,670)

Estimate Std. Error t-value Estimate Std. Error t-value Estimate Std. Error t-value

β0 0.0 0 0262 ∗∗∗ −6

2 ∗ 10 128.77 0.0 0 0224 ∗∗∗ −6
2 ∗ 10 119.82 0.0 0 0348 ∗∗∗ −6
2 ∗ 10 146.58
β1 0.0 0 0 015∗∗∗ 3 ∗ 10−6 5.65 0.0 0 0 013∗∗∗ 2 ∗ 10−6 5.77 −0.0 0 0 012∗∗∗ 3 ∗ 10−6 –4.06
β2 −0.0 0 0113∗∗∗ 2 ∗ 10−6 –53.69 −0.0 0 0 076∗∗∗ 2 ∗ 10−6 –38.78 −0.0 0 0203∗∗∗ 2 ∗ 10−6 –83.65
β3 −0.0 0 0 030∗∗∗ 3 ∗ 10−6 –10.32 −0.0 0 0 032∗∗∗ 2 ∗ 10−6 –13.19 −0.0 0 0 0 07∗∗∗ 3 ∗ 10−6 –2.17
Panel B: One Minute Frequency

Control Group EUR-GBP (T=4,236) AUD-USD (T=4,012) GBP-USD (T=3,670)

Estimate Std. Error t-value Estimate Std. Error t-value Estimate Std. Error t-value

β0 0.0 0 0258∗∗∗ 3 ∗ 10−7 918.53 0.0 0 0219∗∗∗ 2 ∗ 10−7 946.95 0.0 0 0340∗∗∗ 3 ∗ 10−7 1048.10
β1 0.0 0 0 015∗∗∗ 4 ∗ 10−7 40.00 0.0 0 0 016∗∗∗ 3 ∗ 10−7 55.43 −0.0 0 0 0 07∗∗∗ 4 ∗ 10−7 –16.58
β2 −0.0 0 0110∗∗∗ 3 ∗ 10−7 –364.32 −0.0 0 0 072∗∗∗ 3 ∗ 10−7 –279.44 −0.0 0 0196∗∗∗ 3 ∗ 10−7 –572.04
β3 −0.0 0 0 031∗∗∗ 4 ∗ 10−7 –74.52 −0.0 0 0 034∗∗∗ 3 ∗ 10−7 –101.64 −0.0 0 0 011∗∗∗ 5 ∗ 10−7 –24.25

All coefficients are significant at the 1 percent level.

Fig. 15. EUR-USD, HH and CC. Fig. 16. EUR-USD, HC and CH Notes: Fig. 15 shows the human maker-human
taker (HH) and computer maker-computer taker (CC) ratios in the EBS market.
Fig. 16 show the computer maker-human taker (CH) and human maker-computer
decimal pip pricing. Fig. 14 shows that the introduction of decimal taker (HC) ratios.

pip pricing significantly reduced market depths. We found similar

results for the buy side of the order book. Market depth declined
following the introduction of decimal pip pricing for a number of
reasons. First, HFT’s implemented the sub-penny jumping strategy
and occupied the top of the order book at smaller volumes. Sec-
ond, some human traders may also have switched from larger to
smaller orders to adapt to the tick size change.
4.4. Maker-Taker structure
In this section, we use transaction data broken down into
categories distinguishing between human (H) and computer (C)
traders. The data include eight categories HHb , HHs , HCb , HCs , CHb ,
CHs , CCb , and CCs where b denotes buyer-initiated trade and s
denotes seller-initiated trade. By adding both buyer-initiated and
seller-initiated volumes, we construct four groups: human maker-
human taker HH, computer maker-human taker CH, human maker-
computer taker HC, and computer maker-computer taker CC. This
allows us to investigate whether there is a change in market
maker-market taker composition between humans and algorithmic
traders following the introduction of decimal pip pricing. Fig. 15
shows the human maker-human taker (HH) and computer maker-
computer taker (CC) ratios. Trade between humans decreased from
approximately 15% under pip tick size conditions to approximately
10% under decimal pip tick size conditions. Meanwhile, trade be-
tween computers gradually increased from 30 to 35% to 40–45%.
The decline in HH shows that humans either trade less with one
another or they have less access to one another in the market.
At the same time, an increasing CC shows that computers trade
with one another more often. This maybe explained as follows: the
lower minimum tick size enabled HFT’s to implement sub-penny
jumping strategies and to post more aggressive limit orders. As a
result, HFT’s occupied the top of the order book and trade more
with one another (higher CC). Human traders did not adopt dec-
imal pip pricing as much as HFT’s and consequently were placed
at the back of the order book. This means that HFT’s lowered the
execution probability of human maker-human taker trades (lower
HH).
Fig. 16 presents the computer maker-human taker (CH) and hu-
man maker-computer taker (HC) ratios. The CH decreased from ap-
proximately 25% under pip pricing to 15–20% under decimal pip
pricing. Over the same time period, HC increased. Volumes of CH
trade did not change considerably after the tick size change. With
higher total volumes following the tick size change, the decline
in the CH share occurred because shares of the other groups in-
creased overall. Regarding HC, after a penny-jumping HFT’s opens
a position, if the price moves adversely it will trade against hu-
mans as downside protection. This will lead to increasing HC.
4.5. Permanent price impact
To examine the permanent price impact under which infor-
mation is incorporated into prices, we use Hasbrouck (1991) VAR
80 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

Table 5
Estimated Coefficients for the Return Equation in the VAR.

Estimate Sd. t-value Estimate Sd. t-value

γ −0.0039∗∗∗ 0.0017 –2.324 α5 −0.0102∗∗∗ 0.0042 –2.444

β0 0.0507∗∗∗ 0.0010 51.820 α6 −0.0078∗ 0.0040 –1.957
β1 −0.0030∗∗∗ 0.0 0 05 –6.480 α7 −0.0105∗∗∗ 0.0040 –2.658
β2 −0.0012∗∗∗ 0.0 0 04 –3.158 α8 −0.0020 0.0039 –0.515
β3 −0.0 0 08∗ 0.0 0 04 –2.273 α9 −0.0088∗∗ 0.0040 –2.229
β4 −0.0 0 07∗ 0.0 0 04 –2.064 α 10 −0.0059 0.0036 –1.661
β5 −0.0 0 06 0.0 0 04 –1.568 α 11 −0.0089∗∗∗ 0.0033 –2.730
β6 −0.0 0 07∗ 0.0 0 03 –2.183 α 12 −0.0067∗∗ 0.0031 –2.168
β7 −0.0 0 02 0.0 0 03 –0.585 α 13 −0.0068∗∗ 0.0031 –2.235
β8 −0.0011∗∗∗ 0.0 0 03 –3.175 α 14 −0.0073∗∗ 0.0032 –2.269
α0 0.0292∗∗∗ 0.0062 4.729 α 15 −0.0063∗∗ 0.0031 –2.024
α1 −0.0783∗∗∗ 0.0056 –13.966 α 16 −0.0060∗ 0.0031 –1.960
α2 −0.0194∗∗∗ 0.0046 –4.261 α 17 −0.0082∗∗∗ 0.0030 –2.786
α3 −0.0144∗∗∗ 0.0044 –3.282 α 18 −0.0052 0.0030 –1.720
α4 −0.0128∗∗∗ 0.0043 –2.987

Notes: Table 5 reports estimated coefficients and heteroskedasticity and autocorrela-

 8
tion adjusted values for the VAR specification in rt = α0 + 18 i=1 αi rt−i + i=1 βi OFt−i +
β0 OFt + γ OFt ∗ Dt + εt , n = 127, 531, R2 = 0.34.H0 : β1 = . . . = β1 = α0 = . . . = α18 = 0, F-
Stat=2,291, significant at one percent level. H0 : i=1 αi = 0, , F-Stat=326, significant at one
18

percent level. H0 : 8i=1 βi = 0, F-Stat=203, significant at one percent level.

model. We use data categorized as HHb , HHs , HCb , HCs , CHb , CHs ,
CCb , and CCs , where b denotes buyer-initiated trade and where
s denotes seller-initiated trade. The difference between buyer-
initiated and seller-initiated volumes provides the order flow. The
sum of the four order flows gives the total order flow of a given
minute. Let rt , the log return of the price at time t, denote the
change in the market maker’s estimate of fundamental value. In
the interest of simplicity, we multiply rt by 10,0 0 0 so that the re-
turns can be interpreted as the percentage change in the exchange
rate multiplied by 100. OFt is the aggregated order flow equal to
the net of buyer-initiated and seller-initiated trading volumes. We
assume that trades have linear price impact (see Kyle (1985) for an
example):

rt = βt OFt + εt (4)

where ε t is information available to the market maker in addition Fig. 17. Lag Selection for the Order Flow.
to information from order flows. Ensuring the exogeneity of ε t and
its interpretation as the market maker’s information uncorrelated
with order flow requires controlling for microstructure friction. For
example, inventory-control effects may cause past trade to influ-
ence the market maker’s current trade price. Furthermore, delayed
adjustments to information on the part of market takers means
that order flows may have lagged effects on trade. This suggests
the presence of an infinite-order autoregressive specification:
∞
 ∞

rt = α0 + αi rt−i + βi OFt−i + β0 OFt + γ OFt ∗ Dt + εt (5)
i=1 i=1

where Dt is a dummy variable equal to one if the tick size is deci-

mal pip and equal to zero if the tick size is pip. The presence of an
intercept denotes that the regression demeans the variables. The
coefficient γ captures the price impact of the tick size change. A
negative sign denotes a lesser price impact of tick size change and Fig. 18. Lag Selection for the Returns Notes: Figs. 17 and 18 represent values of the
a positive sign denotes more significant price impact of tick size Bayesian Information Criteria (BIC) for the lag selection of the order flows and the
change. To find the number of lagged variables, we compare the returns in Eq. 5.

Akaike Information Criterion (AIC) and Bayesian Information Crite-

rion (BIC) to up to 30 lags of past returns and order flows. Fig. 17
Table 5 reports estimated coefficients and heteroskedasticity- and
reports the BIC for the lags of order flow and Fig. 18 provides the
autocorrelation-adjusted p-values for the VAR specification used in
BIC for the lag of returns. Based on the values of AIC and BIC, we
Eq. 6.
choose 18 lags for the returns and 8 lags for the order flows, pro-
As was expected, the estimate of β 0 (0.0507) is positive and sig-
viding us with the following equation:
nificant at one percent level. This means that the positive order

18 
8 flow (excess demand) increases the rate of the return in the mar-
rt = α0 + αi rt−i + βi OFt−i + β0 OFt + γ OFt ∗ Dt + εt (6) ket. The coefficient of the tick size effect, γ (-0.0039), is negative
i=1 i=1
 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82 81

and significant at one percent level. This indicates that the price All remaining errors are our own. Ramazan Gençay gratefully ac-
impact of trade decreased following the introduction of decimal knowledges financial support received from the Natural Sciences
pip pricing. A lesser price impact is always interpreted as an im- and Engineering Research Council of Canada and from the Social
provement in market quality. However, one may argue that a lesser Sciences and Humanities Research Council of Canada.
price impact comes at the cost of human trades being front-run by
HFT’s. In order to determine the impact on the informativeness of Appendix A
order flow, we show how the VMA representation of the VAR spec-
ification is affected by the tick size dummy variable. We consider the general case of sub-penny jumping in the
interbank FX market. Suppose that x is the rate of return and

P 
P
rt = α0 + αi rt−i + βi OFt−i + ε1t (7) x ∼ N(μ, σ 2 ). We will discuss the case of a buying sub-penny
i=1 i=0 jumper, as the selling case is very similar. Once the penny jumper
trades, the orders he front-runs protect him from serious losses on

P 
P
his position. The returns are unbounded on one side and limited
xt = α0 + γi rt−i + δi OFt−i + ε2t (8) ( p+τ ) −τ
on the other side at a = p−p+ τ = p+ τ.
i=1 i=1

     f (x ) f (x ) φ (α )
f ( x|x > a ) = = = where
rt a (L ) b( L ) ε1t P rob(x > a ) 1 − F (a ) 1 −
(α )
= (9)
xt c (L ) d (L ) ε2t a−μ
α=
σ
where b(L ) = b0 + b1 L + b2 L2 + . . . + bk Lk . The coefficients in the
VMA lag polynomials are the impulse responses implied by the

VAR. Positive b(1 ) = ∞ i=0 bi shows the possibility of informed
traders meaning that quotes respond permanently to trade innova-
tions (see Payne (2003)). Computing the VMA representation and
calculating the impulse response shows that an unexpected mar-
ket buy leads to an upward quote revision of around 0.050% before
The sub-penny jumping leads to higher conditional expectation
the tick size change and around 0.046% after the tick size change.
of returns with smaller variance.
We found that b(1) is a monotonically increasing function of β 0
and since the tick size dummy coefficient γ is negative (equal to- φ (α )
E (x|x > a ) = μ + σ λ(α ), where λ (α ) = >0
0.0039, see Table 5), b(1) decreased after the introduction of deci- 1 −
(α )
mal pip pricing.15
λ ( α ) > 0 → μ + σ λ ( α ) > μ → E ( x|x > a ) > E ( x )
5. Conclusions

V ar (x|x > a ) = σ 2 (1 − δ (α )) where δ ( α ) = λ ( α )[ λ ( α ) − α ]

EBS is the main interdealer market for currency pairs EUR/USD,
USD/JPY, EUR/JPY, USD/CHF, and EUR/CHF. EBS decided to alter the
tick size, the minimum price improvement, from pip pricing (four 0 < δ (α ) < 1 → V ar (x|x > a ) < V ar (x ).
decimal points) to decimal pip pricing (five decimal points) in
March 2011. This decision changed the EBS market structure sig- If the minimum tick size decreases from pip pricing τ 1 to dec-
nificantly. Our analysis shows that the new environment enabled imal pip pricing τ 2 , the loss limit will shift from a(τ 1 ) to a(τ 2 )
HFT’s to front-run human traders via sub-penny jumping. Our find- since
ings indicate that the spread decreased following the introduc- p − (p + τ ) −τ da(τ ) −p
a= = → = < 0.
tion of decimal pip tick size. However, benefits of spread reduction p+τ p+τ dτ ( p + τ )2
were mostly absorbed by HFT’s. The absolute value of the realized
spread also decreased meaning that the market maker should suf-
fer less adverse price moves. This occurred in combination with a
significant drop in market depth. The tick size change altered the
market maker-market taker composition of human and algorithmic
traders. While the share of the computer maker-computer taker
value from total trades increased, the share of the human maker-
human taker value decreased following the tick size change. The dE (x|x > a ) dE (x|x > a ) dα da d λ (α ) −p
= =
new market structure also led to less significant price impact. dτ dα da dτ d α ( p + τ )2

Acknowledgement φ (α ) d λ (α ) −αφ (α )[1 −

(α )] + φ (α )φ (α )
λ (α ) = → =
1 −
(α ) dα [1 −
(α )]2
The authors would like to thank editor Geert Bekaert and the
three anonymous referees for their valuable input. We are deeply d λ (α ) dE (x|x > a )
→ = λ ( α )[ λ ( α ) − α ] = 0 < δ ( α ) < 1 → <0
grateful to Alain Chaboud and Angelo Ranaldo, for their generos- dα dτ
ity and extensive input. This paper has been presented at the Uni-
versity of Cambridge, London School of Economics, University of dV ar (x|x > a ) dV ar (x|x > a ) dα da d δ (α ) −p
= = −σ
College London, Simon Fraser University, the University of Victoria dτ dα da dτ d α ( p + τ )2
and 11th World Congress of the Econometric Society. We are grate-
ful for the comments and suggestions made by the participants.
d δ (α ) d λ (α ) d λ (α )
= [λ ( α ) − α ] + [ − 1]λ(α )
dα dα dα
15
Tseng et al. (2017) find similar conclusions using Huang and Stoll (1997) model. = λ(α )[(λ(α ) − α )2 + λ(α )(λ(α ) − α ) − 1]
Payne (2003) compares his results with Huang and Stoll (1997) as a benchmark.
82 S. Mahmoodzadeh, R. Gençay / Journal of Banking and Finance 85 (2017) 69–82

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