Should illiquid stocks, which may trade tens of thousands of shares per day, be treated the same way as those issues trading tens of millions of shares per day?
For Paul Daley, head of product development at SunGard's Fox River Execution Solutions, the answer is "no."
Highly liquid issues benefit from tight spreads, often never more than the minimum one-cent trade increment. However the smaller, less liquid issues tend to have spreads larger than five cents.
When traders quote prices for these illiquid stocks, it is much easier for other traders to jump the order queue bidding one-cent better, or "pennying the quote," explains Daley.
As part of the Jumpstart Our Business Startups (JOBS) Act, which the Obama administration signed into law in April 2012, the legislation instructed the US Securities and Exchange Commission (SEC) to investigate alternatives to the one-cent trade increment for small and mid-cap companies.
Three months later, the regulator released its report to the US Congress citing a wider variety of academic research on the detrimental effect that more than a decade of decimalisation has had on small- and mid-size capitalised stocks.
Yet the regulator recommended that "the Commission should not proceed with a specific rule making to increase tick sizes... but should consider additional steps that may be needed to determine whether rule making should be undertaken in the future."
The easiest way to address this issue is to have a multiple tick-increment pilot, collect the data and let market forces determine which tick-increment is preferred by market participants, suggests Daley.
One possible solution would be to have a single exchange operator that runs multiple protected quotes to keep one quote at the current one-cent trade increment and have a second quote with a five-cent trade increment.
A few issues would need to be addressed, such as exempting the market with the five-cent quote increment from current National Best Bid and Offer (NBBO) requirements under Regulation NMS, acknowledges Daley.
Yenning for a change
Quoting bids and offers in multiple trade increments is not novel in the global equities markets: It's how the Japanese equities markets work.
The Tokyo Stock Exchange (TSE) uses 11 different tick increments, which are based on a stock's price per share. On the low end, if a stock trades at 3,000 yen or below, its tick size is one yen. On the other end of the scale, if a stock trades at 50 million yen or more, its tick size is 100,000 yen. Between the extremes, the exchange quotes in 5-, 10-, 50-, 100-, 500-, 1,000-, 5,000-, 10,000- and 50,000-yen increments.
SBI Japannext and Chi-X Japan, the operators of the local alternative trading systems (ATS) or proprietary trading systems (PTS) take the process a step further by trading in increments that are one-tenth the size of the exchanges.
Others in the industry, like Pragma Securities CEO David Mechner, see multiple trade increments not only benefiting the more illiquid small- and mid-sized capitalized stocks, but the highly liquid large capitalized stocks as well.
Based on his firm's research, Mechner recommends that the market adopt sub-penny pricing for these stocks. "If there is a $5 stock that trades 20 million times a day, it should have a tenth-of a penny spread," he says. "Of course, exchanges would need to change their existing rebate schedules since it would not make economic sense to provide a 3-tenths of a cent rebate for a tenth of a penny spread."
Not all market participants believe that such market structure changes would improve the market's performance for all investors and be worth the cost of converting from decimalisation.
There needs to be a minimum trade increment, agrees Niall O'Malley, a managing director and portfolio manager at Baltimore-based Blue Point Investment Managers. "Going sub-penny just increases the dependency on high-frequency trading which have been shown to seek the same exit door when the market needs liquidity."
Converting to multiple trade increments that are greater or less than a penny would not be as difficult for the industry as its original migration to decimalisation, argues Jeff Bell, executive vice president and head of clearing and technology group at Wedbush Securities, but he questions if it is the right choice to make given the impact that it would have on the proprietary and third-party risk management, trading, reporting and other related systems that would require updating.
Without hard data that a pilot program would provide, all the conversation on multiple trade increments will be based on assumptions, which tend to be "net wrong," says. Daley. It would be easier to run a pilot and find out, he adds.