Industry players are encouraged by new legislation that authorizes the Securities and Exchange Commission to increase the minimum trading increment for stocks of certain small companies.
Under the Jumpstart Our Business Startups (JOBS) Act, Congress directed the SEC to examine the impact of decimalization on liquidity in small and middle capitalization companies as well as any impact on the number of initial public offerings. Congress is worried that penny ticks have led to less liquidity in smaller companies. That, in turn, has led to a drop-off in new listings and, consequently, fewer jobs from startups.
Once the SEC has completed its study, the Act authorizes the regulator to designate a larger tick size-between 2 cents and 9 cents-for the stocks of so-called “emerging growth companies.” As defined by the JOBS Act, these are companies with revenues of less than $1 billion that have been public for less than 5 years.
“Before decimalization you had wider spreads and more size,” said Patrick Healy, a principal at the Issuer Advisory Group, and a former executive with New York Stock Exchange specialists Bear Wagner. “The concept of a nickel or dime minimum tick for less liquid stocks is a no-brainer.”
Industry players like Healy believe that a larger tick size will encourage quoting in size by market makers. The firms will make more money, which will allow them to spend more on research. More published research will confer greater visibility on the stock. With more research and greater size in the quote the stocks will become more attractive to investors.
“If you set the tick wide enough and there is enough profit incentive for middlemen to come in to make markets, then those middlemen will have an economic incentive to write research,” Jeffrey Solomon, chief executive officer at investment bank Cowen and Co., told members of the House Financial Services Committee at a hearing last month.
Actually, with a market capitalization of about $300 million, the stock of Cowen Group, parent company of Cowen and Co., fits the definition of a small-cap company. It is followed by only two analysts and trades about 300,000 shares per day.
Assuming a single dealer controlled all trading in the stock, its one-cent spread would only generate $3,000 a day in profits, Solomon told the committee. “Why write research when they don’t have much incentive to do so?” he asked. “It’s a big issue.”
Tom Joyce, chief executive of Knight Capital Group, seconded Solomon. A former senior trading executive at Merrill Lynch, Joyce told the committee: “At Merrill, we only made markets in names in which we had research coverage. So there are many firms out there that will tie research coverage to market making.”
The industry moved to decimalization in stages during 2000 and 2001. The one-cent tick gradually replaced the then minimum increment of 6 1/4 cents. Spreads quickly followed suit, collapsing from 6.25 cents to a penny. The relatively tiny spread slashed dealer profits. Since then, the number of Nasdaq-registered market making firms has dropped from over 500 to about 125.
Despite the sharp drop in spreads, evidence of a comparable drop in quoted size is lacking. Quoted size prior to decimalization for less active securities ranged from 4,600 shares to 6,600 shares, counting both bid and ask shares, according to studies done post-decimalization by the Federal Reserve Bank of Chicago and various academics.
In recent years, comparable figures are actually greater, according to data supplied by Knight Capital Group for a 2010 study conducted by a trio of academics titled “Equity Trading in the 21st Century.” The data shows quoted depth in October 2009 in the Russell 2000 index stocks lying within six cents of the market’s best quotes is approximately 7,000 or 8,000 shares. Again, that is the average of all shares at both the bid and the offer.
“The paper shows posted liquidity has, in fact, risen,” Larry Harris, one of the study’s authors and a professor of finance and business economics at the University of Southern California, told Traders Magazine. “There is no indication we have a big problem.”
Even if tick sizes were increased for small-cap stocks, there is no guarantee the move would accrue to the benefit of investment banks or issuers, sources say. Harris notes that the business of market making has largely been taken over by extremely efficient high frequency and medium frequency trading houses.
“Those dealers don’t even exist anymore,” Harris, a former SEC economist, said. “And they won’t exist with wider spreads either. They’ve been displaced by electronic traders who are orders of magnitude more efficient and disciplined.”
Still others argue that while increasing spreads will likely lead to more posted size, it will not necessarily lead to more trading. That’s because the cost of trading goes up. “The wider the spread, the more size up on the spread,” noted Dan Mathisson, Credit Suisse’s head of equity trading for the Americas. “But the flip side to that is the customer will spend more in crossing the spread. So, it’s not that simple. What the regulators need to be concerned about is ‘does the investor end up, on average, with a better or worse price?'”
One investor suggests the additional liquidity may be worth it. Kevin Cronin, global head of equity trading for Invesco, testified at last month’s hearing on behalf of the Investment Company Institute. He told the committee: “One of the things we look at when we invest in companies is liquidity. So we are supportive of participating in a pilot program with traditional tick sizes being moved from a penny to five cents or more.”
