Are higher trading costs justified if they produce more support for small- and mid-cap stocks?
That question is at the heart of a debate among trading practitioners, regulators and academics as the Securities and Exchange Commission mulls the introduction of a pilot that could quintuple the size of the minimum trading increment.
Any such move would widen spreads, and thereby increase investors’ costs, but could also potentially increase liquidity in small-capitalization stocks. In theory, market makers would step up their quoting in the small names.
To a certain extent, which side of the debate a trader falls depends on his trading style. For price takers, if the minimum trading increment increases, then crossing the spread-hitting the bid or lifting the offer-becomes more expensive. But for price makers-those asset managers who prefer to post limit orders on exchanges-a bigger tick would reduce their risk.
Kevin Cronin, global head of equity trading at Invesco, is in the latter camp. “Why don’t we post bids and offers in small-cap stocks?” asked Cronin, speaking at an SEC roundtable in February. “Because the price increment is a penny. It involves a minimal amount of risk to jump in front of an order. If there are more incentives to post bids and offers for institutions, then it will change the attraction for that security. Five cents is a much more meaningful increment.”
Brian Conroy, president of Fidelity Capital Markets, part of the big mutual fund company’s brokerage arm, was also part of the roundtable. He is worried about an increase in trading costs. “We are concerned that if there are changes in decimalization, or an increase in tick sizes, that our transaction costs would go up with no discernible benefit to the end investor,” Conroy told the SEC. “The traders on our investment management side would say they don’t want partners when buying and selling positions. We’d rather have it remain an agency market,” he said.
Conroy became president of Fidelity’s agency brokerage in 2011. Before that, he spent six years as head of global equity trading at Fidelity Investments.
A Rollback
Under “decimalization,” a set of rule changes that went into effect in 2000 and 2001, the minimum trading increment was reduced from 6.25 cents to a penny. The 80 percent cut eviscerated spreads, which caused hundreds of market makers to shut their doors. Investors benefited, however, as trading costs shrunk dramatically.
Any move to increase the minimum trading increment would, in effect, amount to a rollback of decimalization for those names. Under the Jumpstart Our Business Startups, or JOBS, Act, the SEC is required to examine the impact of decimalization and consider an increase in tick sizes.
If the SEC did increase the minimum trading increment from a penny to a nickel, for example, a market maker could see his trading profits quintuple. Under the current tick regime, a firm that trades 100,000 shares in a given day, for instance, makes $1,000. With a 5-cent increment, that would rise to $5,000.
On an annual basis, that amounts to about $1.25 million-up from $250,000. The increase could encourage broker-dealers to invest more in research and marketing of small-cap names.
Proponents of bigger ticks argue they are good for small companies and, therefore, the country. If ticks are bigger, then dealers will commit capital to trade these names and liquidity will increase. So too will dealer profits. With those profits, brokerage firms will spend more on research and marketing of these stocks.
The healthier environment for small-cap stocks will then lead to more initial public offerings. The newly public companies will, in turn, step up their hiring, proponents argue.
“Widening increments will enable firms like mine to begin initiating more research on small-cap companies,” Jeff Solomon, chief executive at Cowen & Co., told the SEC during its February roundtable. “That will, in turn, spawn the necessary liquidity for new issuers-IPOs that will raise capital to hire more people.”
While there is optimism that a larger increment would lead to more aggressive quoting and trading by dealers and others, there is some doubt as to whether more trading would lead to more research coverage.
“I am skeptical that we would see small investment banks provide more research coverage if tick sizes were higher,” Kent Womack, a finance professor at the University of Toronto, told the SEC during the roundtable. “I spoke with a couple of research directors and they were dubious.”
Chris Concannon, a partner at Virtu Financial, a market-making firm, told the SEC at the February meeting that Wall Street’s big banks are having enough difficulty getting paid for their large-cap research.
“Banks don’t even think about small caps,” he said. “We could go to a dollar [tick] and still not solve the research issue. That’s how expensive research is. It’s a problem the market has to solve. Playing with market structure to solve that dynamic will be too costly for the end investor.”
Focus on Liquidity
Tighter spreads may not be not the primary cause of the research pullback by brokers, anyway. The global research settlements of 2003, which outlawed the sharing of investment banking revenues with brokerage research departments, and a shrinking commission rate are also to blame.
“Several developments in recent years have made the environment more challenging for brokers to trade and cover a small company,” Colin Clark, a senior vice president at NYSE Euronext, told the SEC in a written statement.
The focus of any pilot should be on its impact on liquidity, and not research, Concannon and others argue. Even a senior official at a research boutique doesn’t expect an uptick in research coverage within the first year of any pilot.
A pilot would be unlikely to encourage new brokerage research to come onto the market, in the estimation of Maureen McCarthy, director of sales and trading at JMP Securities. “You may not see an improvement in the level of research,” she said at the roundtable. “It takes three to six months to put out a research piece on a single name.”
McCarthy is even skeptical that an increase in the minimum trading increment would cause new market makers to pick up the stocks. “It might bring in existing players, but it is unlikely to bring in new participants,” she said.
At least one buyside executive agrees with her. Rob Glownia, an analyst at RiverFront Investment Group, a Richmond, Va.-based money manager with $3 billion in assets, told Traders Magazine that the human element is important for liquidity in small caps, but bigger ticks are not the way to increase liquidity.
“At nickel spreads, would small-cap liquidity be that much better? Is that really enough edge to incentivize the broker to provide institutional-size liquidity on an ongoing basis?” he said. “I’m not sure. But I’m skeptical.”
Of the total 4,686 common stocks traded on exchanges, there are about 3,320 “less-liquid” names, according to research conducted by NYSE Euronext. These are stocks whose volume averages less than $10 million per day. Of those, nearly half already trade with spreads greater than a nickel, NYSE found.
At least one SEC official wondered why it is necessary to raise the minimum increment when so many stocks already trade with fat spreads. “Why don’t already wide spreads provide motivation to gain profits and produce the research?” Greg Berman, associate director of the Office of Analytics and Research in the SEC’s Division of Trading and Markets, asked during the roundtable.
Cromwell Coulson, president and chief executive of OTC Markets, operator of a quotation and trading system used by over-the-counter dealers, told Berman that penny ticks were to blame. Despite the fact that spreads were wide, dealers refrained from quoting in size because it was too cheap for another trader to better their quote and impact the price of the security. “You are not really incentivized to show much size if someone can pop ahead of you for 100 shares,” Coulson explained.
Coulson believes that increasing the minimum trading increment would cause more shares to cluster at fewer trading points, benefiting the market.
Still, for some sophisticated trading firms, the dearth of displayed liquidity is not a problem. Enrico Cacciatore, a senior trader at ING Investment Management, who trades small cap names, calls raising the minimum increment a “pointless exercise.”
“You’d be saddling me with an increased minimum spread cost,” he told Traders Magazine. “People tend to think in terms of pennies, but forget basis points. A 20-basis-point cost-which is what it would be in some of these names-is just unacceptable.” Cacciatore, who does the vast amount of his trading electronically, said he has little difficulty finding liquidity in small-cap names. The shares just may not be on display.
“It’s about systematically interacting with available liquidity and allowing for a natural transfer of risk,” he said. “It’s a process of creating virtual blocks using a combination of dark and lit markets. Too many people focus on the NBBO when the true non-displayed liquidity is vastly different.”
