High-frequency trading has arguably led to an increase in liquidity and tighter spreads in many of the top S&P components. Issues like Bank of America (BAC), and Ford (F) have an abundance of liquidity as these algorithmic market makers compete with each other to capture liquidity rebates and scalp the spread. Unfortunately, there is a much different story in the small- and mid-cap space. In fact, once you venture into the smaller market capitalization world, many of these stocks seem to trade by appointment only.
Declining volumes, wide spreads, and a lack of liquidity have made these issues a nightmare for any trader looking to execute an order of even moderate size. The declining volume and lack of liquidity in the small caps has the Securities and Exchange Commission (SEC) concerned as well. They recently held a roundtable discussion on evaluating concerns relating to the tick size, and have proposed a pilot program which would explore the possibility of widening the tick size in certain issues, in order to encourage liquidity providers.
The logic is that a wider tick size would offer market makers more potential profits and encourage them to quote more aggressively in these securities.
The wider tick would also eliminate penny-jumping in these securities. On many small caps with wide spreads, there are automated penny-jumping algorithms that can discourage liquidity providers. Our traders complain about this constantly. If a trader places a limit order to buy the stock at $25.05, the auto-penny jumping program automatically bids $25.06. If they go $25.07, the penny-jumping program moves to $25.08. If they cancel their order, the penny-jumping algorithm cancels as well. It is difficult to play a market making role in these illiquid securities when there is an automated program stepping ahead of you by a penny.
Some of our traders have resorted to using hidden order types in illiquid securities to avoid the penny-jumping. This helps with the penny-jumping, but it is still difficult to get executed (because nobody knows your order is there).
Increasing the tick size, in theory, should eliminate the penny-jumping and provide more return to the market makers in the form of wider spreads. But would it really bring more liquidity to the small-cap space?
For market makers, it is all a game of risk-return. In a high frequency trading world, where things happen very quickly, adverse selection risk has increased substantially for market makers, especially in thinly traded issues. A sudden fall in the S&P futures, a breaking news event, or even a sudden order flow imbalance, and a market making limit order risks getting picked off by a more informed algorithmic trader. The return has to justify the risks taken, and in the small-cap market those risks can now be substantial.
Increased adverse selection risk is one factor that discourages market makers in the small-caps, but the most pressing issue affecting displayed liquidity in the small-cap space might be the rise in off-exchange trading.
Looking at the consolidated tape data for May 2013, the TRF (trade reporting facility that reports off-exchange transactions) rose to 36.2 percent of total volume. This compares with 31.1 percent in May 2012, a significant increase in the past year. And the proportion of off-exchange trading is even higher in the small caps. Stocks with an ADV (average daily volume) of fewer than one million shares had 40.3 percent of their volume occur away from the exchanges in May.
The problem with so much volume migrating off exchange is that displayed market makers constantly find that despite the stock trading at their limit price, their limit orders often remain unexecuted.
This is because a large number of market orders, which would have normally interacted with the market maker’s limit orders, are now routed to Over the Counter market makers that trade directly against that order flow. They simply match or slightly beat the displayed quotation, without having to display any quotes of their own.
With so many orders being executed off-exchange, many liquidity providers feel like they are simply setting the price, taking the risk, and not reaping the rewards of getting the execution. Couple that with the increased adverse selection risk, and you have a market in which many participants are hesitant to quote.
Our traders have learned this the hard way. They have found that the only time their limit orders are executed is when the price blows right through them. Bright Trading agrees, and we have advised our traders that there is no longer a favorable risk-return ratio for providing liquidity in the small caps. We have told our traders they should avoid trading these issues, but if they still choose to, they should use more liquidity taking orders. That way their limit orders are not exposed to the adverse selection risk. Some recent academic studies cite similar concerns.
CFA Institute published a study in October 2012 on dark trading, where they raised concerns that the incentive to display limit orders in the public markets can be undermined by certain off-exchange trading practices. Results showed that when a majority of trading in a stock (greater than 50 percent) occurs in undisplayed venues, market quality deteriorates. The CFA Institute says that one possible explanation is that when dark trading dominates, investors could withdraw quotes because of the reduced likelihood of those orders being filled (source: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2012.n5.1, page 58).
With the TRF market share for stocks with an ADV of under one million shares at 40.3 percent in May, and dark trading volumes that occur on the exchange (estimated to be 5.09 percent by Rosenblatt Securities), we may be coming dangerously close to that 50 percent threshold. In fact, many individual securities are already exceeding that threshold.
In looking at the TRF market share stats for stocks trading under one million ADV, 1,927 stocks had a TRF market share above 50 percent. This compares with only 1,108 stocks in May of 2012. Not only is the 50 percent threshold being exceeded, the number of stocks exceeding that threshold is growing.
And some of the regulators in other countries are already taking action.
ASIC (Australian Securities & Investments Commission) expressed concerns in a recent report that excessive dark trading can lead to price deterioration on the exchange. They have enacted new rules to govern dark trading, including a minimum price improvement threshold. The Canadian regulator introduced similar rules back in October.
While a wider tick size, in theory, would seem to be a logical answer to the lack of interest in the small-caps, the SEC may have to go further. They may need to look at internalization and the rise in dark trading volumes if they really want to improve market quality in the small cap space.
Dennis Dick is a CFA, and trader at Bright Trading LLC.
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