Decimalization and Market Quality

Abstract

This paper uses a new data base to examine the impact of decimalization on market quality, payment for order flow, and member profits. I examine changes in these measures following the adoption of decimalization by the Toronto Stock Exchange. The data base employed lists the identities of each party to trade as well as the purpose of the trade. I find that, as predicted, execution costs reduce for low priced and high volume stocks. Also, consistent with predictions is a reduction in market depth. Although direct payment for order flow is not allowed in Canada, another form of it is allowed - internalization. I am able to identify those trades that have been internalized against a member's inventory account. Recent theoretical academic papers argue that decimalization will eliminate payment for order flow. I find that decimalization has a negligible impact on internalization. With respect to member profits, I find that decimalization has a negligible impact on trading profits, and may also result in higher commission profits.

JEL Classification: G15, G18