Proposals by US industry body the Security Traders Association (STA) for wider tick sizes to improve liquidity in small- and medium-cap stocks could having a detrimental effect, potentially “turning the clock back 20 years”, according to market participants.
Earlier this month, the STA published a comment letter in response to the ‘Tick Study’ requirement outlined in the Jumpstart Our Business Startup (JOBS) Act, which recently passed into law in the US. Under the act, the Securities and Exchange Commission (SEC) must examine decimalisation’s impact on the number of IPOs, its effect on the liquidity of securities in small- and medium-sized enterprises (SMEs) and whether there is ”sufficient economic incentive” to support trading operations in these securities in penny increments.
The association, which represents securities trading professionals globally, argues that decimalisation of stock trading has seriously damaged the depth of markets for micro-, small- and mid-sized companies, where displayed quotes for less than 100 shares at any given price level are common. The number of IPOs has decreased in recent years, while market fragmentation across multiple trading venues and price points has only exacerbated the situation, says the STA. In addition, the multiplicity of price points due to the introduction of penny increments has increased costs for long-term investors and especially when investing in SMEs.
“The aggregation of volume that would occur at wider minimum price variations would improve market transparency by showing the real depth of the market at any price and would also lower the cost per share to settle and clear trades,” stated the STA document.
Taking issue
However, market participants have expressed scepticism that the proposals to introduce wider tick sizes would have a beneficial impact on market liquidity. Instead, some observers have cast the proposals as backward looking and unworkable to work in practice.
“This paper is both interesting and frightening,” said Kevin Callahan, CEO at long-term investor-focused trading venue the AX Trading Network. “It advocates forcibly turning the clock back 20 years – to mandate companies to trade in nickels rather than pennies – in the hope that an outmoded business model will return. Forcing investors to buy and sell in nickel increments, when every other service they buy in the economy is available in pennies, is a strange concept that goes against basic consumer choice.”
The STA suggests that a two-year pilot scheme should be implemented, to test out the possibilities for improving liquidity in small- and medium-cap stocks by introducing mandatory nickel price increments for SMEs. But while Callahan agrees that improving liquidity in SMEs should be a capital markets priority, he insists that more regulation is not the solution. He also disputes the notion suggested in the paper that a widening of tick sizes might help reduce volatility in small- and mid-cap stocks because high-frequency traders will be less attracted to those stocks.
“We don’t need more rules and restrictions that add cost for end-investors,” he said. “We need innovative solutions that use technology to create and improve liquidity in small- and mid-cap companies. If you’re trading in nickels, that’s a higher percentage of the value of each company – so volatility almost by definition is going to increase in these stocks.”
With much market making activity currently dominated by large, sophisticated electronic market making firms that have made significant investments in technology, Callahan believes that a return to traditional market making practices is unlikely in current market conditions.
“Asset correlation has reached a very high level, to the point where only such large firms have the sophistication to make markets effectively,” he said. “You’re not going to bring traditional market makers back into the market with a rule change – it’s still going to be dominated by large-scale high-frequency trading firms. All that would achieve is to fatten their profits.”
Constructive criticism
Other market participants have suggested that the SEC should consider alternative ways of boosting SME investment, such as improving the accountability of market participants, providing incentives to reduce odd-lots, and broadening the number of variables taken into consideration when assessing liquidity levels for SMEs. Robin Strong, market strategy director for the buy-side at technology provider Fidessa, says reducing tick sizes in the US market had been seen as beneficial to liquidity for all market participants prior to the introduction of decimalisation – underlining the difficulty of making any single metric a key component of reform.
“There are other options than forcing a change in the
pricing increment,” he said. “I don’t see how widening the tick size would
stabilise the market. Institutional investors are concerned about their market
impact and they rely on breaking up their orders. If regulators mandate wider
spreads, that will just hurt liquidity – and that’s not in anyone’s interests.”
Instead, Strong suggested that it would be better for the SEC to consider introducing market maker obligations for high-frequency trading firms, to ensure that reliable quotes are posted and market participants feel confident enough to trade in size. While some investors might fear high-frequency traders sweeping the book, reliable market making should allow institutional-sized trades to go ahead, he added.
Following he flash crash, in conjunction with a ban on stub quotes, registered market makers are required by the SEC to submit quotes no more than 8% away from the best bid or offer for stocks covered by the circuit breakers implemented in reaction to the event (+/-30% for other securities).