A Securities and Exchange Commission idea to bring more trading to the displayed markets goes too far for some trading officials and not far enough for others. To draw more quotes and better price discovery to the displayed markets, the regulator broached the idea of trading in increments of less than a penny for lower-priced National Market System stocks. The topic came to light in the SEC’s recent concept release on the structure of the equities markets, a document meant to open up discussion about the state of the market.
This sub-penny quoting idea would mean using increments of half-a-cent, a tenth-of-a-cent or less on stocks that trade between $0 and $5 or $0 and $10. Dark pools, which have been capturing a growing percentage of business in high-volume, low-priced stocks, already trade in lower increments, industry pros said.
Exchanges and some kinds of high-frequency traders like the idea, as it would likely improve business. Long-onlys on the buyside are opposed. They say quoting lower than a penny would make their jobs harder.
This isn’t the first time the sub-penny quoting idea made headlines across the industry. In 2003, Nasdaq filed with the SEC for permission to conduct sub-penny trading. At the time, ECNs such as Island, Instinet and Brut, among others, could trade sub-penny. The SEC rejected the request.
Supporters of sub-penny quoting say it would encourage market makers to quote these stocks on displayed markets. This would bring more flow to public markets, thereby improving the quality of the market.
For certain very active securities, trading in sub-pennies make sense, said Cameron Smith, general counsel at Quantlab, a Houston-based quantitative trading shop that uses high-frequency-trading strategies. With these names, traders see tremendous liquidity in the displayed markets on both the bid and the ask. There’s too much size and too many orders crowding at one increment, he said, which forces everyone there to wait for an execution. Dark pools have provided an answer.
"For a market maker who’s internalizing, or somebody in a dark pool, it’s very easy for them to match the price in, say, Citi when it’s too wide," Smith said. "But if it was trading efficiently down to a sub-penny, and that was the price they needed to match, it would be much more difficult, and therefore a lot more of the volume would be done at the exchanges, and customers would get a lot better prices."
The problem, as the SEC sees it, is that too much trading done off-board leaves too little quote competition in the displayed markets to produce the "true" price. The SEC champions price discovery and limit order display above everything. If everyone is hiding in the dark, the thinking goes, then there isn’t enough competition to generate the highest bid or lowest offer.
According to a mid-January research note from Macquarie, the minimum increment rule creates spreads on displayed markets that are "artificially wide." Consequently, market makers and other liquidity providers are able to make money by capturing the spread by matching–or only slightly improving upon-those quotes.
The amount of volume affected is significant. In January, about 2,800 National Market System stocks traded for $10 or less, according to data from Nasdaq OMX. That was 36 percent of all 7,900 NMS stocks. These names accounted for average daily volume of 2.6 billion shares, or 29 percent of the total.
Among the sub-$10 stocks most actively traded are Citigroup, Sirius XM Radio, Dry Ships and E*Trade.
A Smaller Number to Fight Over
By and large, money managers don’t trade low-priced names. Still, buyside traders think sub-penny quoting is the wrong move. One head of equities trading for a traditional money manager, who declined to give his name, said the buyside isn’t asking for such a move.
"It’s just a smaller number to fight over," he said. "It would make stocks seem like they’re moving more than they are."
Another head of equity trading at a long-only firm said she didn’t even want to move to penny increments from sixteenths. "What is this going to do to spreads and commissions?" she asked. "They’re already too low as it is. This is a bad idea."
In January 2001, the New York Stock Exchange started quoting in pennies, down from sixteenths, and from increments of eighths before that. Later, Rule 612 in the SEC’s Regulation NMS officially set minimum pricing at a penny. With penny increments, bid-ask spreads shrank.
Leveling the Field
According to the Macquarie research note, the displayed markets have been losing market share to off-board trading over the past two years. In January 2008, 18 percent of equities trading volume was executed off-board. This past January, the number was 31 percent.
Part of the reason for this was because traders in low-priced, high-volume names, such as Citi, have been able to supply price improvement, often by no more than a thousandth of a penny, or simply match the national best bid and offer off-board in dark pools or wherever while avoiding exchange fees, according to the analyst note.
The exchanges see the idea of sub-penny quoting as a way to compete with dark pools more fairly.
"[Sub-penny quoting] gets us on a level playing field," said Brian Hyndman, senior vice president of Nasdaq transaction services. "If you look at the dark pools today, they can quote in finer increments than a penny, and they have a lot of sub-penny executions."
Low-priced stocks are big business at Nasdaq. Roughly 30 percent of its listed stocks trade for $5 or less, Hyndman said, adding that it’s 15 percent of the exchange’s listed volume. About 56 percent of Nasdaq-listed securities trade for $10 or less. They represent around 35 percent of Nasdaq volume, he added.
Any increase in quoting that a lower trading increment would instigate would benefit Nasdaq’s bottom line, the Macquarie report said. Reducing today’s trading increment below a penny could lower the overall cost of trading by lowering the implicit costs, the report said. And with lower transaction costs, more trading strategies would become profitable.
"If sub-penny increments help shift 5 percent of market volume from off-exchange to on-exchange," the Macquarie report said, "we would expect around a 7 percent lift in both transaction revenue and consolidated tape revenue, with little incremental costs."
Both Hyndman and Smith think the proposal does not go far enough: Tinkering with tick sizes shouldn’t stop with lower-priced stocks. The SEC should also look at higher-priced names.
"The SEC needs to look at tick sizes for various stocks–and not just finer tick increments for low-priced stocks," Hyndman said. "We also need to see if we need to go to wider tick increments for some of the higher-valued stocks."
For its part, the NYSE generally supports the concept but, like Nasdaq, is not pushing the issue. The Big Board doesn’t see sub-penny quoting as something that could help it restore lost market share, said NYSE Euronext spokesman Ray Pellecchia.
"We don’t see this having a significant impact on our exchange business," he said, speaking for NYSE Euronext’s exchanges.
At a Security Traders Association of Chicago meeting last month, though, NYSE Arca’s head of trading operations, Paul Adcock, told a panel of exchange and ECN representatives that sub-penny quoting could be positive for the markets.
"I am a big fan," he said. "I’d like to see it expanded, whether out to $5 or $10. I’d like to see that happen."
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