From Monday US equity markets will become the test bed for a radical pilot scheme aimed at boosting liquidity in thousands of its smallest listed stocks.
“This is not just a tiny corner of the market. While individually these stocks are illiquid, in sum they add up to about 11 per cent of all US equity trading. That’s more than 600m shares trading per day,” says Philip Pearson, director of algorithms at ITG, the broker-dealer.
Why is it being introduced?
The number of companies listed on US exchanges has fallen by half from highs of more than 7,000 in the 1990s. The small-cap sector has been particularly hard hit.
“The decline of new public companies is reducing the growth opportunities for US investors,” said Mary Jo White, chair of the Securities and Exchange Commission, the main US markets regulator, in 2014. “If the downward trend continues, the strength of the US equity markets can be compromised.”
In the same two-decade period there has been a quiet revolution in daily share trading. Big shifts such as decimalisation of prices and electronification has accompanied fragmentation. The number of share trading venues — either exchanges, alternative providers or bank-owned platforms — has mushroomed. Commissions on share trading for intermediaries were squeezed to the bone compared with 1990.
Policymakers are exploring if there is a link between the two big trends. The 2012 Jobs Act asked the SEC to consider widening the minimum quoting and trading increments, or tick sizes.
The thinking ran that widening the spread quoted by brokers would boost their profits, allowing them to support more equity research and encourage more companies to go public.
What’s being proposed?
It will affect stocks under a $3bn market capitalisation with average daily volume of less than 1m shares and an average minimum price of $2 a share. Affected stocks will be quoted in increments of $0.05 cents a share, and not pennies.
The pilot will be split into four groups: a control and three test groups. Monday represents only the first part of a phased-in approach. The SEC scaled back earlier plans for a “big bang”.
It is unclear precisely how many shares will be affected, but roughly a couple of thousand will come in scope.
“The tick pilot sounds very simple, but it is actually three pilots and thousands of symbols and it is two years long,” said Charles Susi, co-head of institutional equities at KCG. “For a broker-dealer it touches every system. That is why it has been almost all hands on deck preparing for it.”
Where are the criticisms?
Many argue that it is a plan driven by ever-shifting winds from Washington, and politicians keen to be seen doing something. In particular Michael Lewis hit a nerve with his best-selling book Flash Boys; A Wall Street Revolt, which portrayed much of US share trading as favouring savvy insiders who knew how to exploit the rules and market plumbing, at the expense of other investors.
Such foundations are shaky for an experiment of this size, critics argue. They charge that it will create additional complexity to the market, not simplify it. The arguing is partly why the plan has taken four years and not the 90 days envisaged by the Jobs Act.
And the experiment will also be considerably different to the original plan. For example, one of the test groups will focus on the controversial, if technical, “trade at” rule. It requires all trades to improve the price of the last trade and has been regularly discussed by the SEC after the May 2010 flash crash.
In theory it will force banks’ internal platforms and other dark pools to send their trades to public exchanges, unless they can execute the trades at a meaningfully better price than available on an exchange. That would make it more difficult for off-exchange venues to compete.
If investors such as asset managers are forced to use exchanges for their large trades, it is unlikely they will get the best price because the world can see their orders.
Depending on the basket, stocks may be eligible to trade at different prices, notes Larry Tabb, co-founder of Tabb Group, a capital markets consultancy.
Ignoring all the carping, will it make a difference?
This is perhaps the toughest question. An analysis from Convergex, the broker-dealer, found that the stocks included those already trading at a median spread of just over $0.05. And even regulators themselves are aware of the plan’s limits. As Ms White noted only 10 days ago: “I agree with many observers, however, that a change in tick size, even if it were to prove highly beneficial, is not likely to fully address the needs of smaller companies and their investors.”