COMMENTARY: Cowen’s Solomon Advocates Bigger Ticks for Smaller Stocks

Earlier this year, Congress took an important, bipartisan step to help support emerging growth companies and stimulate job growth in the country by passing the Jumpstart Our Business Startups Act, aka the JOBS Act

While this is a significant effort help small companies better compete, grow and thrive as public companies, action is needed to address ways to change capital market structures to better support trading in those stocks.

Trading in small-cap, publicly traded companies — those with less than $2 billion of market worth-tends to be thin and relatively opaque.

That puts those stocks at a significant disadvantage to their mid and large-cap peers.  For many institutional investors, the cost of investing in small cap stocks can be prohibitive as the lack of liquidity often affects their ability to accumulate positions. 

Moreover, once a position is established, investors are concerned about how they ultimately will reduce exposure as holding illiquid small cap stock can impact their ability to sell at a time of their choice. 

Thus, despite the potential upside in an investment, if an investor can’t get out of a position when appropriate, he’s more likely to pass on taking that unnecessary risk.

Without natural liquidity, institutional investors often cannot look at buying small-cap stocks out of a fear they will not be able sell the stock.  Retail investors face similar problems. 

This directly impacts capital formation for new companies since many initial offerings of stock are for companies that will have small capitalizations. 

While the JOBS Act does not directly address this challenge, Congress did recognize its importance by requiring the Securities and Exchange Commission to complete a study on increasing the minimum tick sizes of small cap stocks as a way of inducing equity market makers to re-enter the market place.

Unfortunately, the current regulatory framework has led to a decade-long decline market participation from traditional investment firms. 

Because of the reduced trading tick-sizes of small-cap stocks, the margins that traders, who used to function as liquidity providers to buyers and sellers, can achieve by trading these stocks in sub-penny increments are extremely low. 

As a result, most market makers have closed up shop or completely turned to electronic trading leaving a deeply fractured marketplace in which many small cap stocks are left without liquid markets to trade.

Many of those firms, who used to write research on small on small-cap companies, no longer do so as it has become increasingly expensive to produce high-quality independent research on the small cap sector given limited economics available to generate revenues.

Without adequate spreads to trade small-cap stocks, banks cannot afford to provide the most important support for small-cap public companies: research, and capital commitment. In a free market economy, it still makes sense for there to be adequate regulations, but those regulations should not impair incentives to drive increased market participation.  

Increasing tick sizes for small-cap stocks will provide the appropriate incentives to create markets for these stocks, while also providing capital to justify trading, research and capital commitment for these companies.  It may even be possible to let small-cap companies set their own tick sizes, so they have greater control on how they compete. 

A multi-year pilot program to test these kinds of changes in the small cap market is clearly in order.

Jeff Solomon is the Chief Executive Officer of Cowen & Co., a director of Cowen Group and serves as a member of the Committee on Capital Markets Regulation. His views do not represent those of Traders Magazine or SourceMedia.