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August 1, 2012

Ticking Up

Larger Tick Size Considered for Small-Cap Companies

By Peter Chapman

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, or 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 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 five years.

Patrick Fay, WFG

"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 specialist Bear Wagner. "The concept of a nickel or dime minimum tick for less-liquid stocks is a no-brainer."

One longtime market maker agrees. "Increasing the spread size has the possibility of increasing liquidity," said Patrick Fay, director of sales and trading at Williams Financial Group in Dallas and a veteran market maker. "Any time you have a better chance of not losing money by providing liquidity, you'll provide more."

Industry players like Fay and Healy believe 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 1-cent spread would generate only $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."