Overestimated effective spreads

Accurate liquidity measurement is important for liquidity timing and order routing. One of the most prevalent measures is the effective spread, defined as the percentage difference between the transaction price and the bid-ask spread midpoint. For example, if the quotes for a stock are $10.00 to sell and $10.01 to buy, the effective spread of a buy trade at $10.01 is half a cent (about 5 basis points).

To see the logic of the effective spread, consider the market maker who sells to the incoming trader. The market maker provides the service of immediate execution, and in return earns a premium relative the fundamental value of the shares. The effective spread captures that premium, using the spread midpoint as a proxy for the fundamental value.

In a new paper, I challenge the use of the spread midpoint when measuring the effective spread. I show that the use of the midpoint leads to an overestimation of the “true” effective spread.

Assume that the fundamental value of the stock in the example above is 10 dollars and 0.25 cents. The effective spread is then asymmetric; 0.25 cents for trades on the bid side and 0.75 cents (three times higher) on the ask side. If traders care about transaction costs, the relatively wide ask-side spread deters buyers, whereas the tight bid-side spread may attract sellers. There are then more traders submitting market orders at the bid side, and the true effective spread is, on average, smaller than the average midpoint effective spread (which is 0.5 cents).

How bad is it? I analyze a sample of five trading days for the S&P500 stocks and find that the effective spread is overestimated by 16% on average. The problem is worse in stocks where the tick size is high relative the trade price. For example, the picture below shows that the effective spreads of stocks priced between $5 and $15 are overestimated by 60%. Stocks priced higher than $100 are unaffected by the bias.

Can the overestimation problem be fixed? I propose that a viable alternative is to measure the effective spread relative the microprice instead of the midpoint. The microprice is a quote-volume-weighted average of the best bid and ask prices, and it is a commonly used proxy for the fundamental value.

Should investors care? Trading in the US stock market is highly fragmented. As an aid to investors struggling to make their order routing decisions, Rule 605 of RegNMS mandates all exchanges to publish their average effective spreads for each stock on a monthly basis. I show that the overestimation influences the ranking of venues. For example, for stocks priced lower than $25, NYSE MKT (abbreviated “ASE” in the graph below) has the lowest ranking when the effective spread is measured relative the midpoint (left side of the graph below). When I instead measure the spread relative the micoprice, NYSE MKT is ranked highest of all the venues! (see the right side in the graph below) The conclusion is that the midpoint effective spread is potentially misleading the order routing decision.

The article in full text is available at SSRN.

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