TRADING STRATEGY
Ana Avramovic
+ 212 325 2438
Phil Mackintosh
+ 1 212 325 5263
Inside the NBBO: Pushing for Wider – and Narrower! - Spreads
Market Commentary
15 May 2013
Spreads Are Tighter Than Ever
Key Points

Many traders would agree that tighter
spreads are good thing.

Indeed, our data show that tighter spreads
translate to lower costs and less trading
off-exchange.

And yet, regulators are discussing
widening spreads.

Interestingly, regulators have also recently
approved plans to narrow spreads.

In this report, we examine the merits of
each plan, consider whether they would
work, and highlight potential problems.
Exhibit 1: Average bid-ask spreads over time (S&P 500 stocks)
100
90
80
70
basis points
We also look at today’s record low spreads
– and whether they could be even tighter.

Bid-ask spreads, currently averaging less than 3 bps for S&P 500
stocks, are at the lowest levels ever. And yet, market participations
continue to question the quality of our market structure. To complicate
the debate, a current regulatory proposal would widen bid-ask
spreads…while another measure was approved last year that allows for
narrower spreads.
60
50
40
30
20
10

2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
0
Source: Credit Suisse Trading Strategy
Spreads are closely related to volatility. Since volatility is sitting near
record lows, similarly record low spreads should not be too surprising.
But when we take a longer view at the history of spreads, two themes
emerge:
Exhibit 2: Spreads vs volatility in 3 regimes
500 -stocks)
Spreads (S&P
vs Volatility
S&P 500 stocks
1. Although the VIX was at comparable levels to today in 2005-2007,
spreads were almost twice as expensive (see box on page 2). They
get even more expensive when we go farther back.
11
2. In the past year, spreads have remained fairly stable despite the
falling volatility (Exhibit 4, page 2).
10
9
We look at both of these below.
Spreads (bps)
8
Electronic trading & competition compressed spreads
7
Our market has experienced a number of structural changes since the
mid-90s: tick sizes went from eights to sixteenths in 1997, and from
sixteenths to decimals in 2001. Electronic and algorithmic trading grew
through the 2000s. Ultimately, these also led to the emergence of a
new market player: the high frequency trader (HFT).
6
5
4
Pre-crisis (2004-07)
Crisis (2008-09)
3
2010-Now
2
0
10
20
30
40
50
60
70
Volatility (VIX)
Source: Credit Suisse Trading Strategy
(212
(
80
HFT is often blamed for hurting market structure and adding unnecessary
complexity to our market. Without debating that, it’s hard to argue with
data, and the data clearly show a decrease in transaction costs (see How
Much is Market Structure Hurting Investors? for the Credit Suisse
Transaction Cost Index). This suggests that competition for top-of-book
position by HFT and electronic market makers may be responsible for
lowering costs.
Global Bid-Ask
Spreads
Exhibit 3: Global
bid-ask
spreads
90
TRADING STRATEGY
Developed
80
Emerging
70
Exhibit 2 (on page 1) showed spreads and volatility since 2004 and
suggests that there are three distinct periods with spreads getting
progressively tighter each time. Most important, in the current, postcrisis period (2010-now), spreads are lower than they ever were for every
volatility level.
Avg Spread (bps)
60
50
40
30
20
Recently, spread compression has stalled
10
6
48
We should all appreciate how tight spreads are, both compared to prior
years, and to the rest of the world (see Exhibit 3). But recent data
suggest we should be seeing even tighter spreads. As the VIX has
trended lower in 2012 & 2013, spreads, especially for smallcaps, have
not kept pace (Exhibit 4).
5
40
Could falling HFT be behind this divergence?
4
32
3
24
2
16
1
8
-
0
India
Germany
Russia
United States
Canada
Netherlands
Belgium
France
UK
China
Brazil
Denmark
Israel
Hungary
Australia
Sweden
Norway
Portugal
Mexico
Poland
Czech…
Austria
Italy
South Africa
Spain
Korea
Hong Kong
Taiwan
Ireland
Singapore
Finland
Chile
Japan
Greece
Turkey
Malaysia
Thailand
Egypt
New Zealand
Switzerland
Indonesia
-
Source: Credit Suisse Trading Strategy
Jan-13
Avg R2K Spread (bps) & VIX Level
We mentioned above how HFT were part of the major structural changes
that increased competition and led to narrower spreads. However, it
seems the field became saturated and compressed spreads to the point
that when volumes and volatility came down, there wasn’t enough margin
to support the enlarged industry. Making matters worse, costs continued
to mount. Faced with these challenges, a number of HFT firms are
making cuts, switching to other asset classes, and, increasingly, shutting
down entirely – over the same period as spreads have widened.
Mar-13
Sep-12
SPX Spreads (left axis)
Nov-12
Jul-12
Mar-12
May-12
Jan-12
Sep-11
Nov-11
Jul-11
May-11
Jan-11
Mar-11
VIX
R2K Spreads (right axis)
Source: Credit Suisse Trading Strategy
The relationship between spreads and volatility
Bid-ask spreads & volatility share a direct relationship. In the
chart below, the darker color corresponds to a higher VIX level.
It is easy to see that the peaks are darker.
volatility of the stock, and the time it takes to get hedged
(based on order book depth). The resulting payoff profile is
similar to a sold call option.
This makes sense as higher volatility calls for wider spreads as
market makers demand greater compensation for the additional
risk volatility brings. Conversely, when volatility & risk decline, we
should expect to pay lower spread costs.
Consequently, we can use a simple Black-Scholes options
model to proxy for spread pricing dynamics: time on the bid is
similar to Theta; the half spread you earn is the in-the-moneyness of the option.
This simplified1 approach provides a mathematical way to look
at the fair value of spreads. Importantly, we see that spreads
should increase as volatility, price, or time to execute increase.
Average bid-ask spreads by volatility regime
10
9
8
Volatility
7
Bid-ask spread (bps)
<15
6
15-20
5
20-30
We also see that the ‘fair’ spread for a stock may be well
above 1-tick – especially for high priced stocks.
30+
4
3
2
1
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
0
Jan-04
Avg S&P Spread (bps)
Avg Bid-Ask
VIX
Exhibit 4: Spreads
vs. Spreads
VIX – vs
recently
diverging
Source: Credit Suisse Trading Strategy.
Posted orders are like written options
Posted orders work a lot like options. The best a bid can do is
collect the spread (premium). But if the price moves up and
takes out the offer, the buyer will have to cover his legged
position. This will cost at least one spread, depending on the
Source: Credit Suisse Trading Strategy.
1
The real world is even more complex, as execution time varies depending on liquidity at the time, order book priority, and the market maker’s covering strategy.
Maker-taker rebates and order book imbalances might also affect the actual moneyness of the spread. But the concept is the same – posting gives a free option
to other participants, and that option has a probability of positive return based on volatility, among other things.
2
TRADING STRATEGY
Exhibit
5: Avg
shortfall
increases
with stock’strades)
spread
Average
shortfall
by bid-ask
spread (medium-sized
0
0 - 1 bps
(avg=0.8bps)
1 - 10 bps
(avg=4bps)
10 - 20 bps
(avg=14bps)
20+ bps
(avg=50bps)
Most of us would naturally think that tighter spreads are better. After all,
real investors are liquidity demanders and need to cross the spread to build
a position.
Wider spreads increase cost…
-5
-10
avg shortfall (bps)
Regulators Call for Wider spreads
Real executions seem to support this view - according to our ExPRT TCA
data, stocks with wider spreads face consistently increasing shortfall costs
(Exhibit 5).
-15
-20
-25
But might they increase liquidity enough to offset this?
-30
Yet, regulators are examining the potential for wider spreads to increase
liquidity in more thinly traded small cap names.
-35
-40
-45
-50
Note: “medium” sized trades shown; pattern is consistent across sizes
Source: Credit Suisse Trading Strategy
As part of the JOBS act, passed in April 2012, Congress authorized the
SEC to increase tick sizes for “emerging growth companies” under the
belief that it would promote liquidity and encourage IPOs. The SEC is
currently holding roundtables to evaluate the impact of changing tick sizes.
Why would wider spreads increase liquidity?
The idea is based on the belief that a larger tick size translates to wider spreads, and that wider spreads will encourage more
market participants to try to capture the spread.
Most importantly, this also assumes that posted size is what defines “better liquidity”. The JOBS act does not consider depth
beyond the top-of-book.
The following example shows the how wider spreads should make the NBBO larger:

In the 1-tick market below, there are only 100 shares on both the $10.12 bid & $10.13 offer. It is likely that the stock that
would be bid at $10.11 and $10.10 would not be displayed as that creates unnecessary signaling.

With 5-cent spreads, the $10.12 bid would join the $10.10 bid. Also, the $10.11 and $10.10 bids that are currently
undisplayed would become lit at $10.10. In total there would now be 700 shares on the bid.

If the same happened on the offer, the spread would be 5 cents wide, and the offer size would be 900 shares.
Source: Credit Suisse Trading Strategy
Exhibit 6: Spreads naturally increase for small cap stocks
Small cap stocks already do have wider spreads
Based on our EDGE pre-trade, small cap stocks already have wider
spreads (Exhibit 6). On average, small cap stocks are more than 8x wider
than large cap stocks (Exhibit 4, page 2). Given their lower turnover and
typically higher volatility, this follows the intuition discussed in the box on
page 2, and supports the view that the market is naturally achieving wider
spreads on small stocks.
Source: Credit Suisse Trading Strategy
3
TRADING STRATEGY
Another path to wider spreads: lower prices
Exhibit 7: Lower priced stocks naturally have wider
Spreads (basis points)
The JOBS act would achieve wider spreads by fixing larger tick sizes.
However, there is another way to get to wider spreads: lower stock prices.
Falling price makes spread relatively larger
A basis-point spread is defined as the spread in cents / stock price. If the
spread in cents is constant, the basis-point spread will increase as the
price falls (Ex 7). This is typical of large, liquid stocks that already trade 1cent wide, since 1 cent is the minimum allowed tick size in the US.
Companies can self-serve!
Now that we’ve seen that lower prices will also widen spreads, we should
also point out that there is a way for companies who think wider spreads
would be preferred to accomplish it themselves: using stock splits.
Do the companies themselves want wider spreads?
Note: dark lines represent the value of each tick (in bps) for each stock price.
1 tick results in a wider spreads (in bps) for lower priced stocks.
Source: Credit Suisse Trading Strategy
Exhibit 8: Number of stock splits declining over time
Number of Stock Splits by Year
(S&P
500
stocks)
(S&P
500 stocks)
140
Number of Regular Stock Splits
120
Despite the fact that companies can increase spreads by cutting their
share price, companies have performed very few stock splits in the past
few years (Exhibit 8). This suggests that, for whatever reason, companies
“like” to have high-priced stocks. Undoubtedly, with US commissions paid
as cents-per-share, investors appreciate the savings. But how does it
actually affect execution quality?
High priced stocks trade more than 1-tick wide anyway
While low-priced stocks have wider spreads, Exhibit 7 shows that spreads
start to widen again when prices get very high (supporting our option
pricing model from page 2).
So although companies resist stocks splits, the market still prices spreads
according to supply-demand and return dynamics. Exhibit 9 shows that
half of all stocks priced below $100 trade 1-penny wide, but for expensive
stocks, half trade 7 or more ticks wide.
100
80
60
Exhibit 10: $Value posted at the NBBO is larger for cheaper stocks
40
20
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
0
Source: Credit Suisse Trading Strategy
Exhibit 9: Expensive stocks have a larger avg tick size
Average tick size of S&P 500 stocks
(S&P 500 stocks)
1
2
1
50%
"regular"
stocks
2
33%
3 4 More
510
68
79
8% 5%2%
1%
0%
3
Should we force wider spreads?
4
We’ve seen that, in practice:

Smallcaps already have wider spreads
7

Lower priced stocks have wider spreads
8

Not all stocks trade 1-tick wide anyway

Companies have the ability to widen spreads themselves, if they so
choose
5
6
stocks
priced
>$100
2
3
11% 7%
4
16%
5 6 7 8 9 10
11% 4% 9% 2%7% 11%
More
22%
9
10
0%
20%
40%
60%
% of stocks
80%
100%
Source: Credit Suisse Trading Strategy
Source: Credit Suisse Trading Strategy
More
These facts raise the question of whether we need to force a process that
seems to already happen naturally. Bid-ask spreads are meant to reflect
market conditions. Arbitrarily fixing them would create distortions and may
unnecessarily complicate the market.
4
TRADING STRATEGY
Exhibit Average
11: Stocks
with wider
have
a higher
% of shares
crossedspreads
by bid-ask
spread
% crossed
(medium-sized
trades)
25%
% of shares crossed
20%
Wider spreads means it costs more to cross the spread and take liquidity.
This should make traders more reluctant to pay the spread and encourage
them to post resting orders on the near touch instead. Hence the logic
that wider spreads should increase posted size.
However, wide spreads may come with other undesirable consequences:
15%
1. Attracts HFT: If the spread is wide enough to be outside the “fair
value” discussed on page 2, it may become a haven for HFT who will
crowd the book in order to pick up spreads.
10%
5%
%
Will It Work?
0 - 1 bps
(avg=0.8bps)
1 - 10 bps
(avg=4bps)
10 - 20 bps
(avg=14bps)
20+ bps
(avg=50bps)
Note: “medium” sized trades shown; pattern is consistent across sizes
Source: Credit Suisse Trading Strategy
Exhibit 12: Wider spreads in HK cause volume to
concentrate in the MOC when spreads are zero
2. Longer time to execute: With more traders – and HFT – now
trying to post on the near touch, the queue will increase and your
time to execute will go up. This is illustrated dramatically by
Citigroup on the next page.
3. Increased signaling and market risk: A longer waiting time
means you’re more exposed to risk – both market risk (that the
market will move against you), and signaling risk (since your order
will be displayed for a longer time).
4. More trading goes dark: To minimize signaling risk and also to
reduce transaction costs (dark pools often provide mid-point
executions), traders may then turn to dark pools. This is one of the
reasons dark pools were invented in the first place. Using our
ExPRT data, we find that stocks with wider spreads do trade more in
dark pools (Exhibit 11).
5. Less intraday liquidity: Volume curves in Asian markets
demonstrate how wider spreads affect trading patterns in the real
world. In Hong Kong, for example, tick sizes are so large and
queues so long that nearly 20% of all activity avoids regular
continuous trading and instead concentrates in the closing auction
(when spreads are zero. See Exhibit 12).
Source: Credit Suisse Trading Strategy
So the ironic consequence of an attempt to increase posted size may
actually be reduced intraday liquidity and a drive to the dark!
Is there another way to “promote liquidity”?
Some have suggested other possible ways to increase posted size – but all of these have potential downsides as well.

Increasing the size of a round lot: The chart at right shows that the median
S&P 500 stock only shows around 5 lots on each side. For Russell 2000 stocks,
it’s only around 2-3 lots. With such small posted size, even a modest increase in
the minimum lot size – from, say, 100 shares to 500 shares – would force posted
size to increase for the many stocks that currently show less than 5 lots.
7
However, there are (at least) 3 potential problems with the approach:
4
Median Posted Size on the Bid/Ask (in round lots)
6
5
1) This would adversely affect retail investors who already need over $80,000
to buy one lot of stocks like GOOG.
3
2) Market makers may be reluctant to commit more capital, so they may restrict
their quoting to fewer, more liquid names.
1
3) Given the higher costs from capital commitment, market makers may widen
spreads as compensation. This raises costs for investors.

8
2
S&P 500
Russell 2000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Credit Suisse Trading Strategy
Creating a separate “institutional” market: In theory, if institutions feel comfortable knowing that they’re interacting with a defined
group of like-minded traders, they may be more willing to show larger size. In practice, these restricted communities have not panned
out. To cite one example, NYSE’s New York Block Exchange recently shut down for lack of interest. This seems to imply that they’re
not the ideal solution either. Aside from not gaining traction, such a scheme would increase fragmentation and complexity as well.
5
TRADING STRATEGY
Exhibit 13: Citi’s posted size ballooned when price fell –
and reverted post-reverse-split
Citigroup: A case study in widening spreads
Citigroup provided a dramatic example of what happens in the real world
when spreads increase. In a highly-publicized collapse, the stock sank
from $50 to $1 in just two years. This caused the bid-ask spread to blow
out from 2bps to 100bps. Although the JOBS act would widen spreads
by increasing the minimum tick size rather than lowering prices, it is
reasonable to assume that the results would be the same. The fallout:
1. Posted size increased (even in $value): Just as the JOBS act
intends, posted size ballooned as spreads increased. Despite the
falling share price, NBBO size increased materially even in $value
terms (Exhibit 13).
Source: Credit Suisse Trading Strategy
Exhibit 14: Time to get through the Citigroup queue
jumped to over 3 minutes
600
500

Before Citi’s low, it took around 5 seconds to get to the top of
the queue.

From May 2009-May 2011, with the book growing 100-fold,
the average wait time jumped to over 3 minutes, reaching as
high as 10 minutes at times.
This exposed investors to more execution risk and longer signalling.
300
200
100
Jan-13
Sep-12
Jan-12
May-12
Sep-11
Jan-11
May-11
Sep-10
Jan-10
May-10
Sep-09
Jan-09
May-09
Sep-08
Jan-08
May-08
Sep-07
Jan-07
-
May-07
Source: Credit Suisse Trading Strategy
3. C allegedly became a haven for HFT: A 100bps spread + 30mil
“maker” rebate (each side) offered by many exchanges made C a very
profitable reversion trade. And HFT, with their low latency, was best
equipped to achieve the price-time priority necessary to make the
trade work. This exaggerated the problems discussed in #2 above.
4. Dark trading increased: We also found that with a lower stock price
and wider spread, volume shifted from the NYSE and Nasdaq to
crossing venues (represented by the TRF – Exhibit 15). This makes
sense since a mid-point execution becomes more attractive as the
spread gets more expense. It also likely explains the fact that we saw
little change in average shortfall despite wider spreads (Exhibit 16).
5. All this reverted after the reverse split: When C completed their
1-for-10 reverse split, the spread reverted to 2 bps, book size and
queue length collapsed back to pre-crisis levels, and TRF volumes
receded.
Exhibit 15: More Citi volume crossed off-exchange
as price fell/spreads widened
Exhibit 16: Average C shortfall costs relatively constant
Average Shortfall
Cost spreads
as more C:
crossing
offset wider
20
10 for 1
reverse split
15
10
5
0
-5
-10
-15
Jan-13
Jul-12
Oct-12
Jan-12
Apr-12
Jul-11
Oct-11
Jan-11
Apr-11
Jul-10
Oct-10
Jan-10
Apr-10
Jul-09
Jan-09
Apr-09
Jul-08
Oct-08
Jan-08
Source: Credit Suisse Trading Strategy
Oct-09
Price hits $1
-20
Apr-08
seconds
400
2. Execution risk & signalling increased as waiting time went up:
Comparing the posted size to the daily value trading in C shows that it
took considerably longer for new bids to get to the top of the book as
the spread expanded (Exhibit 14).
Source: Credit Suisse Trading Strategy
6
TRADING STRATEGY
Regulators ask for smaller spreads too!
Our study is complicated by the fact that there are other market
participants who also have strong arguments for switching to sub-penny
ticks that would narrow spreads.
Eliminating the latency advantage
One argument for narrower spreads is that it will remove the advantage
that low-latency traders have. Anyone wanting priority will only need to
offer stock inside the latest spread to create a new best offer.
Of course this argument doesn’t consider potential system-wide issues
that non-integer prices might create, including needing more space to
show the best bid/offer prices and upgrading technology to be able to
handle the increased complexity. It is also possible that exchanges might
need to recode systems to accept more decimals in bids and offers.
Exchanges want it both ways
Ironically, exchanges support the JOBS act to widen tick sizes – but
they’ve also successfully lobbied the SEC to modify regulations that allow
them to use smaller ticks (sub-penny).
The motivation behind the new Retail Liquidity Program is to “level the
playing field” with dark pools and internalizers who are able to execute
trades between the NBBO. .
Exhibit 17: Japan’s tick sizes have artificially created
among the widest spreads globally
Japan Exchange goes sub-yen
Interestingly, the Japan Exchange Group recently announced the
implementation of a pilot program to reduce tick sizes to a tenth of current
levels. Proprietary trading systems – akin to ATS’s in the US – already
employ these smaller increments, so the change would make them more
competitive with PTS’s.
Beware of Unintended Consequences
There are compelling arguments to both widen tick sizes and reduce them.
However, it is extremely difficult to introduce targeted regulation given how
complex our market is.
We’ve also shown that investor costs are at all-time lows, and that the
market already does a pretty good job of appropriately assessing risks and
pricing them accordingly.
Source: Credit Suisse Trading Strategy
Regulation that forces different spreads for an arbitrary class of companies
might result in unintended consequences and increasing market
complexity. It may increase the percentage of stocks that trade in dark
pools or attract more HFT fighting for rebates.
Perhaps we should be more concerned with why bid-ask spreads have
started to widen, even as volatility continues to decline. Our data shows
that this is more likely to increase trade costs for real investors – and at
the end of the day, isn’t that what matters most?
7
TRADING STRATEGY
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8