NON-STATIONARITY IN BID-ASK SPREADS: THE ROLE OF TICK SIZE REDUCTION

Mean-reversion of spreads follows directly from an error correction quote adjustment process plus a random walk theory of the quote midpoint as an implicit efficient price. In such a model, buys and sells are equally likely, and the trade direction is informationless. With asymmetric information and strategic trading, however, order flow is serially correlated, and the spread incorporates a time-varying adverse selection component that conditions on trade direction (or more generally, on order flow imbalance). We test the mean reversion of tradeto-trade spreads for every NYSE stock for each year 1993-2006 and find that tick size reduction in 1997 and 2001 substantially reduced the incidence of mean-reverting NYSE spreads. We attribute this growing non-stationarity of spreads to “legging” in the bid and ask quotes, and relate the reduced resiliency of the NYSE book to arbitrage threshold bounds relative to the radically declining tick size. In addition, we show that mean-reversion tests are very sensitive to lag structure misspecification and evaluate three approaches to selecting an optimal lag structure. (KEYWORDS: spread, mean-reversion, stationarity, tick size)