In less than six months, the Securities and Exchange Commission and equity-market participants will begin to discover if bigger is better when the two-year tick pilot for illiquid stocks begins.
The pilot may improve the liquidity of illiquid stocks by increasing their tick size from $0.01 to $0.05, and thereby the width of their spreads. However, the proposed program doesnt address improving the market quality of highly liquid stocks by reducing the size of their ticks, according to some industry insiders.
We all care about the ability of small companies to raise capital, said David Mechner, CEO of Pragma Securities. However, the efficiency of the market for liquid stocks really has a lot more impact on the investor’s pocket book in the end. Having more granular tick sizes for stocks that need it would actually be very beneficial and could also help mitigate some of the concerns that people have around high-frequency trading.
If the tick sizes for the most liquid stocks were chosen more appropriately, institutional investors would not see spreads that were several ticks wide that often attract pennying trading strategies from other market participants, he added.
Pragma Securities is a Manhattan-based quantitative trading technology and analytical services provider. This summer, the firm released a report entitled New Trading Patterns Around the WM/R Fix that reveals how recent changes to the calculation of the WM/Reuters spot FX rate, coupled with a shift in how banks handle client orders, have created unusually predictable patterns in the FX markets. Mechners firm also found that algorithmic traders are poised to improve their performance trading in and around the window.
Investors and exchange operators also would enjoy narrower bid-ask spreads, shorter order queues and higher on-exchange market share, according to James Angel, associate professor at Georgetown Universitys McDonough School of Business. Electronic liquidity providers and trade internalizers would likely earn less from the narrow spreads, Angel said.
Stocks that already have tight spreads of two or three ticks and deep bid and ask queues would be perfect candidates for smaller tick sizes, according to Pragmas Mechner. By reducing the tick size to $0.001, the spreads would remain two or three ticks wide, but the overall spreads would shrink from $0.02 to a possible $0.002, he explained.
The tighter spreads also would lead to less liquidity because the new spreads would not be as lucrative for market-makers, but there would also be far less pennying of orders and more sustainable liquidity, Mechner added.
Far From a Done Deal
The equities market already has the equivalent of sub-penny pricing via the maker-taker rebate model used by many exchange operators, according to Georgetowns Angel.
By paying market orders and charging limit orders, the exchanges allow people to jump to the front of the queue for less than one tick, which is sub-penny pricing, he explained. Those exchanges are active only in the stocks whose ticks are too wide. Explicit sub-penny pricing would eliminate the need for such exchanges, and they would lose market share to other platforms.
Other issues, such as fear of thinner markets, might hamper potential adoption of finer tick sizes for more liquid issues.
Thinner inside markets would make trading institutional block orders more difficult, acknowledged Pragmas Mechner.
Modern exchanges are not a great place for block trading, he added. If people want to do block trading, they should be doing it upstairs, or in a dark pool that is designed to facilitate block trading.The core market structure should really support the way that most people trade most of the time, which is basically algorithmic trading.
In addition, creating a new tier, or tiers, of tick sizes would be a complex proposition for the entire industry and not just for the exchanges.
People have to keep track of what those tick sizes are and so forth, Mechner explained. Obviously, there’s a willingness to undertake that kind of complexity if you look at what’s happening with the tick pilot, and a lot of rules end up having stock-specific components or parameters to them.
Angel does not discount a certain level of bureaucratic and institutional inertia that such a proposal would need to overcome: I haven’t seen a big push for this, but it could be part of an overall tick size update after the pilot program is finished.
