The Securities and Exchange Commission is preparing a review to see if raising the minimum trading increment for so-called “emerging growth companies” and other small-cap stocks could increase liquidity in these thinly traded names.
The review is mandated by the Schweikert Amendment, a component of the Jumpstart Our Business Startups Act. The bill was passed by Congress and signed by President Obama on April 5.
The broad goal of the JOBS Act is to increase job creation and economic growth by improving access to the public capital markets for what the bill defines as emerging growth companies–those with less than $1 billion in annual revenue.
The Schweikert Amendment, named after Congressman David Schweikert, R-Ariz., requires the SEC to study the effects of the transition from fraction trading to decimal trading, which occurred in 2001.That move, encouraged by Congress, cut the minimum trading increment from 6.25 cents to a penny.
The SEC study will include the effects on initial public offerings and liquidity for small-cap companies. The outcome may include a repudiation of decimalization, increasing the minimum trading increment, or tick, for emerging growth stocks. Any increase in the minimum tick would naturally widen out spreads. That could cause traders to increase the size of their quotes, which would likely increase liquidity for the stock.
It is unclear if any SEC decision would affect existing small-cap stocks or just those EGCs that have yet to go public.
“I think many of our problems with market liquidity in small and mid-caps can be traced right back to decimalization,” said Dennis Dick, prop trader at Bright Trading in Detroit. “Where decimalization has helped to reduce spreads in the large-cap space, it has actually harmed liquidity in the small- and mid-cap space.”
For blocks, “It’s nearly impossible to execute any sizable order without significant price impact,” Dick said. “Our firm would be a proponent of this move to wider spreads, such as a nickel.”
The SEC has 90 days to report to Congress on the impact of penny trading after enactment of the JOBS Act.
After the report is delivered to Congress, the SEC then has 180 to increase the trading increment for emerging growth companies. That increase would be greater than 1 cent but less than 10 cents. But that would occur only if the agency finds that penny tick increments have hurt small-cap or emerging growth companies’ access to capital.
On April 11, the SEC issued a notice requesting comment on its requirements under the JOBS act, including the study to review minimum tick size and possible changes to the trading increment.
One source familiar with the SEC’s thinking said that increasing spreads would change the direction of recent market reforms, such as decimalization and Reg NMS, both of which have led to tighter spreads and, presumably, better prices for investors. While the regulator is already busy with Dodd-Frank and the Volcker rule, the SEC will take the time to study the topic further, he added.
“I am sure that the SEC will carefully consider the results of its study of whether increased spreads would promote capital formation for smaller issuers before taking any regulatory action,” the source said. “Conceivably, it could do a pilot program if the study suggests that such a step is warranted.”
And a pilot study is something the Street will likely support, since it will make sure the SEC is aware of unintended consequences from changing tick size. Joe Ricciardi, managing director and head of cash trading at Knight Capital, favors a pilot program.
“It’s definitely worth studying changing the tick size,” Ricciardi said. “Due to the intricacies of market structure, everything in this industry should be done on a pilot program. I’m not against this type of study, whether it’s to go to either wider or narrower spreads. You need to run a pilot program.”
At least one industry executive is skeptical that the minimum increment will go back up.
“I wouldn’t underestimate the difficulty of achieving wider spreads, said Greg Tusar, managing director and head of Goldman Sachs Electronic Trading, at the recent Security Traders Association of New York conference. “But from the standpoint of aggregating liquidity, it may make sense. It will be interesting to see.”
