Market participants have mixed views over the introduction of smaller tick sizes by the Tokyo Stock Exchange (TSE) in January, with some anticipating a quick boost in execution performance and others warning of unintended risks.

Compared with proprietary trading systems (PTSs) such as SBI Japannext and Chi-X Japan, the TSE’s tick sizes – the minimum movement of a stock price – are quite wide and therefore more costly. (Generally the narrower the tick size, the narrower the bid/ask spread is for the stock.)

As PTSs’ trading speeds and tick sizes are often one-tenth of those at the TSE –  SBI Japannext boasts a very low latency, or delay, of 40 microseconds, which allows for some 40,000 orders to be processed per second – PTSs have attracted trading volume away from Tokyo’s main bourse.

As such, the TSE has taken upon itself to implement a tick-size reduction via a three-phase process. During the first phase, the TSE will shrink tick sizes of all Topix 100 index components priced higher than ¥3,000 ($29) affecting tick sizes of ¥5 yen and above.

By July 2014, the TSE will move towards decimalisation and introduce new tick sizes of ¥0.1 and ¥0.5, reducing tick sizes on stocks priced at below ¥5,000. At this point, TSE’s tick sizes will be on par with those of PTSs.

In addition the TSE has been working on improving latency to below one millisecond (the blink of an eye normally takes about 300 milliseconds).

David Logerais, head of Asian trading for Amundi, notes that wide tick sizes are a common headache for investors trading Asian exchanges, adding that many Japanese stocks trading with a bid/ask spread above 80bp are at unacceptable levels - other markets outside Asia tick sizes of 15-20 bp are more common. As such, he says he hopes other Asian exchanges will follow TSE’s footstep.

While SBI Japannext chief executive officer Chuck Chon welcomes TSE’s move to stay competitive by reducing tick sizes, he notes that making such a large leap towards decimalization is not without risks.

“The cost of business will become higher for the TSE because their system and infrastructure would need to be upgraded to be able to handle a plethora of orders and market data,” Chon says. “At the same time, while top-tiered brokers may be able to upgrade their infrastructure to cope with the sudden increase of data load, mid or smaller-tiered brokers may not be able to afford the same level of investment.”

Industry players are also interested to see how TSE’s plan to reduce tick-sizes will affect the competitive edge currently offered by PTSs, such as SBI Japannext.

Once the TSE fully implements all three phases of its tick-reduction programme, expected to be complete by mid-2015, many anticipate the TSE will be able to level the playing field and even potentially recapture some of the lost trading volume.

Chon cautions of a repeat of the “tick-size war” that happened between US bourses and alternative venues over the past decade, which lead to endless undercutting of spreads between operators. Smaller ticks (at one penny, down from 1/8 of a dollar back in the 1990s) led to an outburst of orders that inundated exchanges’ systems. (As tick sizes get thinner, order sizes reduce and thus, the number of orders increases.)

In the case above, US exchanges could not keep up with the regulator’s rule on enforcing its “order protection rule" the requires trading venues to prevent executions done at prices less than the national best bid and offer. The entire trading community suffers as a result, Chon notes.

Chon cautions that what is right for the US may not be for Asia, hinting that if necessary, SBI Japannext will seek ways to be more competitive in attracting liquidity on its platform. He declined to offer specific examples.

Meanwhile, Shilesh Shekhawat, JP Morgan head of Asia electronic trading solutions and product management, says her team is expecting an increase in market data as well as the number of trades that her team will be receiving on the back of the tick size reduction by the TSE.

Additionally, “smaller tick scale to be introduced by the TSE could indirectly lead to more orders being executed electronically”, she adds.

But Shamu Thambi, an executive director at Morgan Stanley’s electronic trading division specializing in market structure and liquidity strategy, says TSE’s move to reduce tick size may not be all bad news for PTSs.

“It could be a positive outcome for PTSs, as investors who previously had not been able to trade in PTSs due to their tick sizes being out of sync with those of the TSE will now be able to trade on these markets,” says Thambi.