Financial Management  Spring 2004  pages 47 - 62 Tick Size, Order Handling Rules, and Trading Costs Kee H. Chung and Chairat Chuwonganant* We show that the effect of the tick-size change on NASDAQ spreads depends critically on the Order Handling Rules (OHR). Our empirical results show that the tick-size reduction has no impact on the spread of NASDAQ issues that were not subject to the new OHR, but has a significant effect on the spread of NASDAQ issues that were subject to the OHR. These results indicate that smaller tick sizes are valuable in reducing market friction only if market makers compete on price with public traders. Our results are in line with the finding of prior studies that execution costs are lower in auction markets than in pure dealer markets. In this study, we examine how market structure moderates the effect of the minimum price variation on execution costs. Our study is in the same spirit of a recent study by Huang and Stoll (2001) who show that the need for and effect of the minimum price variation rule are a function of market structure. The New York Stock Exchange (NYSE) is an auction market in which both the specialists and public traders (through their limit orders) establish prices. In contrast, until 1997 NASDAQ was a quote-driven dealer market in which dealers established prices. However, with the implementation of the new Order Handling Rules (OHR) in 1997, NASDAQ has become more of an order-driven auction market like the NYSE. Prior studies (see Huang and Stoll, 1996; Barclay, 1997; Chung, Van Ness, and Van Ness, 2001; and Huang and Stoll, 2001) show that traders incur greater execution costs in dealer markets than in auction markets. Heidle and Huang (2002) show that the probability of encountering an informed trader is higher in dealer markets than in auction markets. Whether one market structure is better than the other is an important concern to regulators as well as traders. It is also of considerable interest to corporate managers, because the location of their stock listings can affect investor trading costs, required returns, and thus the cost of capital. Prior studies show that stock returns are significantly and positively related to the bid-ask spread (see Amihud and Mendelson, 1986, 1989; Amihud, Mendelson, and Lauterbach, 1997; Amihud, 2002; and Easley, Hvidkjaer, and O’Hara, 2002). Tick size and order handling rules are two important protocols of securities markets that affect trading costs and market quality. Tick size affects market quality because it limits the prices that traders can quote and thus restricts price competition. Order handling rules affect market quality because they determine the nature and degree of competition among market participants in the price discovery process. In this study, we show how tick size and order handling rules affect execution costs on NASDAQ. On June 2, 1997, the minimum price variation (i.e., tick size) on NASDAQ was reduced from $1/ We thank an anonymous referee, Lemma Senbet and Alex Triantis (the Editors), Bidisha Chakrabarty, William Christie, Bob Hagerman, Thomas McInish, Robert Wood, and session participants at the 2001 FMA conference for valuable comments and helpful discussions. The authors are solely responsible for the contents of the article. * Kee H. Chung is the M&T Chair in Banking and Finance at the State University of New York (SUNY) at Buffalo. Chairat Chuwonganant is an Assistant Professor of Finance at Indiana University-Purdue University at Fort Wayne.