Abstract:The stock market is one of the most important financial markets in a country. In recent decades, many financial markets have changed their trading
rules to achieve higher market quality (e.g. market liquidity, market volatility and price efficiency). This thesis focuses on three important trading rules—tick size, secondary priority rule and price limit—and tests their influence on market quality based
on agent-based artificial stock markets (ASMs), which are agent-based order-driven simulated stock market models. Unlike empirical market data, ASMs ensure that the trading rule is the only exogenous variable varying between experiments. Given the lack of
a consensus method for determination of the fundamental stock price in real stock markets, previous empirical studies have generally focused on market liquidity and volatility. However, as the fundamental stock price can be set in ASMs, in addition to liquidity
and volatility, price efficiency can also be analysed. Therefore, in this thesis, the market quality is investigated from a more comprehensive perspective, including that of market liquidity, volatility and price efficiency.
Tick size, the minimum change in stock price in stock markets, is the first trading rule to be investigated in this study. Two types of tick size
system are investigated: uniform tick size and stepwise tick size systems. Under the uniform tick size system, the tick size is the same for all stocks in the market. By testing the market quality with tick size 1, 0.1, 0.01 and 0.001, the results show that
smaller tick size can improve market quality, while an extremely small tick size would damage it. The price stepwise tick size system—where tick size increases with price—and volume stepwise tick size system—where tick size increases with decreasing trade
volume—are then investigated. The results indicate that both price stepwise and volume stepwise systems could promote market quality in different ways. These results might be expected as the price stepwise system is mainly designed to limit noise in markets,
while the volume stepwise system is used to balance the benefits for liquidity suppliers and demanders. Based on the performance of the price stepwise and volume stepwise systems, a combination stepwise tick size system is designed and investigated in this
study to test whether it combines the advantages of the two systems and further improves market quality. A combination stepwise tick size system as proposed and supported by Goldstein and Kavajecz (2000), but has not been adopted in real stock markets. The
tick size in a maximal combination system or minimal combination system is determined by the larger or smaller tick size in the price stepwise system and volume stepwise system, respectively. Consistent with expectation, the results indicate that a combination
system, especially a minimal combination system, can further promote market quality.
The secondary priority rule, which determines how the quoted order in the market is matched, is the second trading rule investigated here. The impact
of various secondary priority rules, including the time priority rule, pro-rata priority rule and equal sharing priority rule, on stock market quality are investigated with consideration given to different investors’ strategies under different secondary priority
rules. The time priority, first-come, first-served rule is the most common secondary priority rule in financial markets, and almost all stock markets choose it as their secondary priority rule. The pro-rata and equal sharing priority rules are generally used
in other financial markets, such as futures markets. The pro-rata priority rule allocates market orders to limit orders on the best price list based proportionally on limit order sizes, while the equal sharing priority rule allocates market orders equally.
Since 2017 the New York Stock Exchange has used the ‘parity’ priority rule, a combination of the time and pro-rata priority rules, which indicates that some stock markets might have realised the importance of the secondary priority rule for market quality
and have tried to identify a more effective secondary priority rule than the time priority rule to promote market quality. Taking market quality under the time priority rule as the benchmark, the results show that the pro-rata priority rule can enhance trading
activity and price efficiency, but can also increase volatility; the equal sharing priority rule may damage market quality with respect to market liquidity, market volatility and price efficiency.
Price limit—that is, setting an established amount by which a price may increase or decrease in any single trading period—is the third trading rule
to be investigated in the thesis. In financial markets with a price limit, trade is prevented from occurring outside specified price bands. The results of previous empirical studies have shown that lower limit hits are followed by price reversals, low volatility
and lower/stable trade volume, while upper limit hits are followed by price continues, high volatility and higher trade volume price limit (e.g. Kim et al., 2013; Li et al., 2014). This provides evidence that the price limit is beneficial when the lower limit
is hit, but harmful when the upper limit is hit. Therefore, a new policy with a lower price limit but no upper price limit (termed the asymmetric limit policy) is proposed here. The market quality under the asymmetric limit policy is tested and compared with
that for a market that adopts the symmetric limit policy (with both lower and upper limits) and a market without limits. The experimental results verify the hypothesis that the asymmetric limit policy can promote market quality significantly. The reference
price, which is the real-time price used to determine the price band under the price limit policy, is another focus of this study. It is found that, compared with the quoted price, the traded price is more suitable as the reference price under both asymmetric
and symmetric limit policies. This finding suggests that the asymmetric price limit with trade price as the reference price might be a feasible policy for stock markets to use to promote market quality.
This thesis examines the effects of changes in tick size, secondary priority rule and price limit policy on market quality, including market liquidity,
market volatility and price efficiency. The results indicate the effectiveness of the minimal combination tick size system, pro-rata secondary priority rule and asymmetric price limit for promoting market quality, which has important theoretical and management
implications for stock markets. Moreover, by investigating trading rules that are still at the theoretical stage, this study indicates that ASMs are an important complement for empirical studies.