Twelve years after the U.S. switched to 1-cent increments for stock trading to save investors money, regulators and broker-dealers are considering a test of larger tick sizes.
A pilot study of bigger quoting increments to improve liquidity in less-active stocks is being debated by executives from exchanges and brokers, market makers and academics at a Securities and Exchange Commission meeting Tuesday. The U.S. moved to minimum ticks of a penny from sixteenths of $1 in 2001. Panelists will also discuss the effect of 1-cent price moves on capital raising and trading.
Proponents say larger increments will spur market makers to supply more buying and selling volume, particularly for less- active stocks, while skeptics say it will cause people to pay more when they trade. An SEC advisory group last week recommended the creation of a stock exchange limited to small companies that have trouble raising capital in public markets as part of efforts to encourage more initial public offerings.
“A test would tell you if there’s a benefit or not,” Jim Maguire, 82, a former New York Stock Exchange specialist who began working at the Big Board in the 1970s and has opposed the move to 1-cent increments since 2000, said in a phone interview. “I assume there would be. The 1-cent spread has been a toxic element in trading.”
The shift to smaller increments enabled retail investors to buy shares at lower prices and sell for more. Combined with the growth of computing power and rules that boosted competition among venues, the process of decimalization decreased the profitability of equity dealers, who used money earned on wider bid-ask spreads to fund analyst research. Smaller tick sizes also complicated the way institutions trade by driving them to use more automated electronic strategies to handle blocks.
The Jumpstart Our Business Startups Act, signed into law by President Barack Obama last April, authorized the SEC to increase the tick size to as much as 10 cents from 1 cent for emerging-growth companies, or those with annual revenue of less than $1 billion. A July study by SEC staff members said that while rulemaking wasn’t immediately necessary, discussions with market participants could generate ideas for a pilot study.
Market makers and dealers need more economic incentives to bring smaller companies public, provide bids and offers and publish stock research, according to David Weild, New York-based chairman and chief executive officer of Weild & Co. and head of capital markets at Grant Thornton LLP. About 150 to 350 IPOs each raised less than $25 million a year from 1991 to 1997, according to data compiled by Grant Thornton. Fewer than 50 did so annually on average starting in 2000, the data show.
“The crisis in capital formation is a product of ill- advised market-structure changes that had massive consequences for small-cap stocks,” Weild, a former vice chairman at Nasdaq Stock Market, said in a phone interview. “The SEC needs to increase tick sizes and make them permanent to improve liquidity. It’s Armageddon for sub-$25 million IPOs.”
SEC rule changes focused on Nasdaq trading in the 1990s blunted companies’ interest in going public by hurting the dealers that facilitated their trading, while later one-size- fits-all marketplace rules ignored the needs of smaller companies, Weild said. The regulator should consider allowing all companies to decide what increment their shares use from 1 cent to 25 cents as a partial remedy, he said.
The Security Traders Association, which represents more than 4,000 financial-industry professionals, recommends a pilot study lasting at least a year with 900 companies of different market capitalizations and trading characteristics such as daily volume and price volatility, according to Jim Toes, president and CEO of the New York-based group.
“There’s not one regulatory or competitive event you can point to and say that’s why IPOs are down, but decimalization is on the list,” Toes said in an interview. “Enhanced liquidity is impossible to measure but it affects investor confidence. It’s time to try a pilot study.”
The types of market makers providing liquidity in the U.S. have changed since SEC mandates in the 1990s, decimalization and Regulation NMS, a set of rules that spurred competition for NYSE when it was implemented in 2007, Brian Conroy, president of Fidelity Capital Markets, the institutional trading arm of Boston-based Fidelity Investments, said in a phone interview. Many of the current biggest market makers don’t provide research or get involved with equity deals, he said.
Revenue fell more than 50 percent for NYSE specialists and 70 percent for Nasdaq market makers from 2000 to 2004, a Government Accountability Office report found in 2005. Regulatory changes, the increase in electronic trading and a 18 percent drop in the Standard & Poor’s 500 Index over those five years cut the number of specialists and market makers almost in half, to about 260 from almost 500, the GAO said.
The squeeze helped give rise to the proprietary and high- frequency trading firms that now account for more than half of American equity volume. Today, with activity fragmented across more than a dozen exchanges and electronic communications networks and about 50 dark pools, venues rely on computerized firms to supply the buy and sell orders that make it possible for investors to trade shares rapidly.
“If you’re a retail client, you’d be concerned that your cost to execute would go up,” said Conroy, speaking on behalf of Fidelity’s mutual fund and institutional business. “We would be wary of market-structure changes that increase execution costs for the vast majority of investors, be they retail or mutual funds. We would also be wary of disrupting what is overall not perfect, but a highly efficient market structure.”
Smaller companies tend to be difficult to trade because of the number of shares publicly available and their concentration of ownership, Conroy said. Still, Fidelity would be open to a pilot, depending on how it’s structured and what it aims to accomplish, he said. Fidelity oversaw $1.7 trillion in client assets as of Nov. 30.
The Investment Company Institute, which represents mutual funds, as well as NYSE Euronext and market makers such as Getco LLC and Knight Capital Group Inc. support experimentation with tick sizes, according to testimony during market-structure hearings held by the House financial services committee last June. The SEC advisory group on small and emerging companies recommended larger tick sizes at a meeting in Washington on Feb. 1.
Niall O’Malley, a fund manager at Blue Point Investment Management LLC in Baltimore, wants to see whether larger increments boost market making in less-active shares and prompt brokers to write more research about those stocks. While it may be a limited change to the current set of rules for U.S. equities, a pilot may improve investor confidence by restraining “unusual price actions,” he said.
“If you make that change for 12 or 24 months, it would allow people to assess it and see how trading is affected,” O’Malley, whose firm oversees about $13 million, said in a phone interview. “It strikes me as one item that could be changed with minimal adverse impact and perhaps the clearest measurable result for the market.”
Richard Lindsey, director of the SEC’s market regulation division in the late 1990s, said regulators should be clear about what they want to determine through a pilot study with larger increments if they choose to experiment with spreads.
“I haven’t seen any academic research that demonstrates there have been deleterious effects from the change in tick size across the size spectrum of firms,” Lindsey, now chief investment strategist in a unit of Denver, Colorado-based Janus Capital Group Inc. that creates investment products, said in a phone interview. “The research shows that while orders execute at more prices and it takes institutions longer to execute big orders, depth and liquidity haven’t changed.”
Depth refers to the number of shares available at different prices, while liquidity refers to the ease of buying or selling. Orders are now spread out over more price levels than when stocks were quoted in fractions.
The push toward decimal pricing in the 1990s came from Congress, the securities industry and regulators as a way to reduce costs for investors. NYSE had minimum increments of one- eighth of a dollar since its formation in 1792 and by 1997 the U.S. was the only major equities market using fractional prices.
Congressmen Michael G. Oxley, a Republican from Ohio, and Edward J. Markey, a Massachusetts Democrat, introduced a bill on March 13, 1997, called the “Common Cents Stock Pricing Act” requiring the SEC to convert prices to the decimal system.
After defending minimum spreads of eighths of a dollar in Congressional hearings in April 1997, NYSE decided to employ decimal pricing. What drove the change was Bernard Madoff’s decision to “break the eighth” by trading at smaller increments through the market-making unit of Bernard L. Madoff Investment Securities LLC, according to Lindsey, the former SEC regulator.
Madoff’s firm and Trimark Securities Inc., now part of Knight Capital, began quoting NYSE companies in sixteenths in May 1997, according to a 1998 paper about the exchange’s shift to 6.25-cent ticks by Jeffrey Ricker, an investment strategist in San Francisco. NYSE cut its increment in June 1997.
Madoff was sentenced to 150 years in prison in 2009 for masterminding the biggest Ponzi scheme in history, which he ran separately from his regulated market-making business.
“Blaming pennies for problems in the markets is going after the wrong culprit,” Ricker, who participated in 1997 Congressional hearings about decimal increments, said in a phone interview. “Expanding tick sizes would decrease the intensity of competition in the market. A bigger spread would put more money in the pockets of high-frequency shops.”
The securities industry should test 0.5-cent increments for active stocks to see whether the current spread is too wide, he said. Narrowing the difference between the bid and offer would save money for investors in the biggest stocks, he said.
NYSE Euronext, Nasdaq OMX Group Inc. and Bats Global Markets Inc. told the SEC in April 2010 that they wanted to try a six-month pilot of quoting shares for 30 securities in half- cent ticks for stocks between $1 and $20 and one exchange-traded fund, according to a letter to the regulator. The SEC didn’t officially respond to the request.
The owner of the New York Stock Exchange still supports that petition, Colin Clark, senior vice president for strategic analysis at NYSE Euronext, said in a phone interview.
“It makes sense to have multiple tick increments,” Clark said. “But for now the primary issue is the illiquids. There are thousands of securities that are extremely illiquid and very difficult for investors to trade. To the extent we can provide some incentives to increase market-maker participation, that could be beneficial.”