The Tick Size Pilot is the most notable change to U.S. equity market structure in a decade, and at Convergex we are watching its progress with considerable interest.
Early results show that the basics of the program are working as anticipated. Most notably, trade size is increasing as volume clusters at the now-nickel increments. At the same time, transaction costs and price volatility are noticeably higher than under the prior market structure. That was to be expected, of course, in the move from pennies to nickels.
We are watching one storyline from the early data with some concern: the possibility that Group 3 stocks are more subject to information leakage generated by large institutional orders than the control group or Groups 1 and 2. The trade at rule applicable to Group 3 seems to be pushing more volume to lit markets (which is fine) but also generating wider spreads and larger bid/ask volumes (which is not). This is causing the largest increase in transaction costs for any of the three groups: 43.5% higher than before the TSP started. Perhaps this is simply a statistical anomaly; regardless, we will continue to monitor it and advise our clients appropriately when they trade in Group 3 securities.
As for the long term goal of the Tick Size Pilot, namely to increase the profitability of market making in small cap securities, that in turn would encourage brokerage firms to fund more research into small cap stocks and ultimately rejuvenate the IPO market, the jury is still out. We suspect that investor enthusiasm for small cap stocks, driven by the U.S. election results, will ultimately spark more research interest in the space than tweaks to market structure. As I wrote in my last note on the Tick Size Pilot program, we believe its utility is to provide a realworld perspective on market structure more generally.
Summary Points:
The post-election day rally has been most noticeably in U.S. listed small cap stocks, which are up 15% (Russell 2000) to 17% (S&P Small Cap 600).
Lost in the excitement of this recent move: the impact of the Tick Size Pilot (TSP) on the trading of less liquid, smaller capitalization stocks.
We ran the numbers to find out how the three test groups of the TSP have fared from 11/1/2016 to 12/13/16, a period that includes the entire Trump Rally.
Our Key Findings:
Bid/ask sizes have increased noticeably across all three groups, anywhere from 176%/189% (Group 1) to 180%/198% (Group 2) and 221%/238% (Group 3). These spreads are less than the anticipated 400% increase (the move from a penny to a nickel) because most stocks in the pilot were already trading wider than a penny before the program began.
Trade size has grown, but not uniformly among all three groups. TSP Group 1, where the only change from prior market structure was a mandated nickel quote increment, has seen the greatest increase in trade size (10.3%). TSP Group 2 (nickel quotes, but some exceptions for midpoint executions, retail or negotiated trades) saw a smaller increase in trade size (9.4%). TSP Group 3 (same as Group 2, but with a limited trade at requirement) saw only a 5.6% increase in trade size.
Transaction costs are up across the board. Measured as the increase in spread in basis points, here are the increases: TSP Group 1: 32.5%, TSP Group 2: 33.8%, TSP Group 3: 43.5%.
Price volatility is also higher. When compared to the control group, stocks in the Tick Size Pilot are showing more volatility since 11/1/2016. The control group saw a 6.0% decline in volatility after that date, whereas TSP Group 1 was 27.1% more volatile, Group 2 was 20.9% more volatile, and Group 3 was 23.1% more volatile.
Inverted trading venues (those that pay rebates for taking liquidity rather than posting liquidity) are more popular execution locations for Tick Size Pilot stocks than those in the control group.
What We Are Watching:
TSP Group 3 has experienced larger shifts in trading patterns than the other 2 groups. As compared to their trading activity before the TSP, these stocks now show larger bid/ask sizes and wider spreads than either of the other two pilot or control groups.
Looking at trading venue market share, Group 3 stocks show another anomaly: they now more often trade in lit markets, even though Groups 1 and 2 have actually seen their volumes shift to Alternative Trading Systems (ATSs). Share volumes reported through the Trade Reporting Facility (TRF – a proxy for dark volume) declined 8.2 percentage points for Group 3 stocks, even though they have increased for the control group, Group 1 and Group 2.
Our concern: information leakage for large institutional orders in Group 3. The trade at requirement has clearly shifted more volume to lit exchanges and simultaneously widened spreads and increased bid/ask size relative to the control group, Group 1 and Group 2. To us, that is a worrisome development. Why is Group 3 seeing greater volumes and spreads? Is it just a statistical anomaly, or are market participants able to see (and profit from) institutional order flow more easily? We will be watching the data in the coming weeks with an eye to answering that question.
Eric Noll is Convergex President and CEO
