Let’s Split The Difference

Recently the SEC asked the industry and the investing public how to more effectively regulate thinly-traded securities (issuers whose shares trade fewer than 100,000 shares daily). This is another chapter in a larger discussion on boosting liquidity, a debate that has assumed many forms and myriad solutions.

One solution for incentivizing trading has been to reduce or eliminate fees. One interesting example is the current rush to zero commissions by the retail brokerage firms. How can they do that? Well, among other things, those firms benefit from selling their customers’ order flow to wholesalers. The payments are substantial. And how do the wholesalers make money? Well, they regard retail order flow as uninformed, non-professional flow that they can reliably trade against without much market impact. What’s more, even though the wholesalers guarantee the national best bid or offer, so much today trades either off-exchange or in between the best bid and offer, that they have plenty of opportunities to make money.

Then there are proposals to concentrate liquidity. This was the hope behind the ill-fated Tick Size Pilot: reducing the number of price points would increase the amount of displayed liquidity and maybe even attract block trading opportunities. Alas, poorly designed and implemented, the pilot proved nothing of the sort. But maybe they went about it in the wrong way.

The SEC now proposes eliminating unlisted trading privileges to concentrate liquidity on the listing exchange; or limiting off-board trading; or creating new incentives for market makers. It’s unclear if any of these would effect meaningful change – maybe, as some have asked, the problem is just lack of interest.

But there are other possible causes, and other solutions. A recent Wall Street Journal article highlighted the unprecedented increase in odd-lot trades in the markets. Odd-lot orders are currently not included in the national best bid and offer and often simply float in-between.  While retail order flow makes up many of those odd lot orders, the increase can also be attributed to the effect of electronic trading and the slicing of orders into smaller and smaller pieces to hide intention and increase profit opportunity. For many of the retail players, the prevalence of odd lots may reflect that some stock prices have simply gotten too high to enter a round lot order. For instance, one share of Google was recently priced at $ 1,260.11, meaning a round lot of 100 shares costs $126,011. What retail investor is making that trade?

You could address the problem by eliminating round lots as outdated artifacts, the same way we eliminated trading in eighths and teenies. After all, round lots were a work-around to facilitate manual trading – when you’re recording trades on chalk boards, calculating settlement prices with adding machines and plain old pencil and paper, and recording transfers in physical ledgers, round numbers are easier to work with. But since computers and algorithms don’t sweat those calculations, maybe we shouldn’t either. On the other hand, round lots may continue to matter because the rules of yester-year reference round lots extensively and the systems of Wall Street have that concept embedded deeply into their infrastructures and processes.

Alternatively, you could lower the individual share price and increase the number of shares – in other words, split the stock. At one time corporations wanting retail investors to own their stock would evaluate when to split their shares, effectively making a round lot more affordable.  But for whatever reason, splits are sharply down as share prices have risen aggressively.  

But splits do something other than make a company’s stock more affordable; a split reduces the number of price points, a backdoor way of implementing a tick size pilot if you will. When a stock splits its shares and the stock that was trading at $100 now trades at $50, then there also has been a reduction of round lot price points from 10,000 to 5,000. Think about what that would mean for a stock trading over $ 1,000 a share! Liquidity automatically would be condensed into those reduced-price points.

And what might be the logical result of that action?  A good guess would be an increase in volume, which for an Exchange means increased transaction fees and market data revenue.  But here’s the funny thing: Exchanges today charge their corporate clients for splits, which are nominally intended to cover the costs of adjusting databases at the Exchange, Clearing Corporation and Transfer Agents. But the fee can be as high as $ 150,000 for one split, which may deter issuers from using this straightforward tool. Wouldn’t it make sense to encourage splits by reducing or eliminating those fees? Listed companies would certainly benefit by a broader base of investors, firms would benefit by higher turnover, as would Exchanges.  

We’d certainly be willing to split the difference!


Daniel Labovitz and Lou Pastina are managing members at Global Markets Advisory Group, a boutique consultancy focusing on capital markets regulation and compliance.

Jack Miller is Head of Global Execution Services at Baird. He oversees the execution function within Baird’s Institutional Equities group and is responsible for driving Baird’s strategic priorities in electronic execution services and related technologies.