To Improve Small Company Liquidity, SEC Chairman Announces Tick-Size Pilot
February 25, 2014
SEC Chairman Mary Jo White gave her state of the Commission speech on Friday at the “SEC Speaks 2014” conference in Washington, D.C. But if you were distracted for a moment by the sight of hoodie-clad Mark Cuban live-tweeting at the conference, you may have missed this one paragraph in the speech:
“In 2014, we also will prioritize our review of equity market structure, focusing closely on how it impacts investors and companies of every size. One near-term project that I will be pushing forward is the development and implementation of a tick-size pilot, along carefully defined parameters, that would widen the quoting and trading increments and test, among other things, whether a change like this improves liquidity and market quality” (emphasis added).
This is actually big news, especially given that the SEC in 2012 recommended against any increase in tick sizes, and the SEC’s Investor Advisory Committee as recently as January recommended against a pilot program to do so. So what’s all the fuss about anyway? Some background is in order here.
For hundreds of years prior to 2001, U.S. equity markets used fractions as pricing increments. Out of concern that the fractional interval system was putting U.S. markets at a competitive disadvantage to foreign equity markets that used decimal pricing, the SEC promulgated a series of regulatory changes beginning in 1997 that collectively shifted our markets from a quote-driven to an electronic-order-driven market and from minimum increments of 1/16th and 1/32nd of a dollar to one penny and below. These regulatory changes are often referred to collectively as the process of “decimalization”.
Although these changes were intended to benefit investors, many prominent market structure experts have asserted that decimalization has dramatically harmed small company capital formation by destroying the economic infrastructure that previously supported those companies. In 2011, my good friend and former NASDAQ Vice-Chairman David Weild characterized decimalization as a “death star”, contending that the current one penny tick size regimen as applied to less liquid stocks is at the root of the systemic decline in the U.S. small company IPO market. According to Weild, it nearly eliminated the economic incentive to trade in small cap stocks by taking “96 percent of the economics from the trading spread of most small cap stocks – from $0.25 per share to $0.01 per share”. Weild has convincingly connected the dots (quite literally in a series of dramatic charts) between the decimalization rule changes and the small company IPO market falling off the cliff promptly thereafter. Weild has advocated for an increase in tick size for smaller cap stocks which he believes will encourage financial institutions to spend more resources covering these issuers and their securities.
Momentum for tick-size reform has been building. Section 106 of the JOBS Act required the SEC to study the impact that decimalization has had on IPOs, and gave it the power to designate a tick size greater than one cent but less than ten cents for quoting and trading emerging growth company securities if the SEC concluded that was necessary to provide sufficient economic incentive to support trading operations in these companies. In its 2012 report to Congress, however, the SEC determined not to increase tick sizes at that time, and instead elected to solicit the views of investors, companies, market professionals, academics and others on the broad topic of decimalization and the impact on IPOs and the markets. Last November, the Equity Capital Formation Task Force proposed a mandatory five-cent increment program for companies with a market capitalization below $750 million. Earlier this month, the U.S. House of Representatives passed a bill requiring the SEC to create an optional five-cent or 10-cent increment for companies whose market cap is under $750 million. The fate of the proposed legislation is unclear, however, because the Senate hasn’t proposed a companion bill.
Order Handling Rules (1997) required specialists and market makers to give investors their most competitive quotes, resulting in more competition between dealers, and set the stage for the shrinking of trading spreads and tick sizes from the longstanding levels of one-quarter and one-eighth of a dollar. Regulation ATS (1998) enabled electronic networks to link orders with registered exchanges, subjecting traditional trading markets to fierce competition and resulting in tick sizes dropping down to as low as 3.125 cents. Decimalization (2001) required stocks to be quoted in decimals instead of fractions and allowed a minimum tick size of one cent. Regulation NMS (2005) allowed quoting and trade execution in sub-penny increments for dark pools, algorithmic trading or broker-dealers providing price improvements to a customer order, exceptions that eventually became the rule.