Market structure debates can sometimes feel so arcane that you’d be forgiven if you preferred to train your attention instead on watching paint dry. But these debates can be important – as is the case with one proposal that is gaining traction.
I’m talking about the suggestion by the Equity Capital Formation Task Force to try and spur more trading in small-company stocks by moving away from “decimalization” – having stocks trade in one-penny increments on exchanges – and going back to the days when the spreads between the bid and ask prices was wider.
Up until the late 1990s, trading was pretty straightforward – you’d want to buy 100 shares of XYZ, and you’d be quoted a figure of perhaps $37 1/4, or $37 3/8; if you wanted to sell, the price might be $37 or $37 1/8. The idea is pretty familiar to anyone who’s ever changed their greenbacks for a foreign currency while on holiday: Not only do you pay a commission, but your rate is set up in such a way that you’ll have to buy high and sell low.
In the late 1990s, the SEC added trading in sixteenths – or “teenies,” as they instantly were dubbed by trading floor denizens – and then, in 2001, came decimalization, with the idea being that a smaller “spread” between the bid and the asked prices would make trading more efficient and less costly.
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Decimalization always had its detractors, although it’s hard to draw a definite link between the pricing change and the problems that critics identify. Yes, price points move more rapidly, meaning that to capture the benefit of low costs, some investors may have to trade more frequently than they did before. But is that frequent movement in prices the result of the change in market structure or the arrival of new players in the trading universe, such as high-frequency trading firms?
Moreover, even if someone has to trade a few more times to complete the purchase or sale of a block of shares, the fact remains that those trades are likely to have less of an impact on the market, meaning that they can complete the trade before the price gets ahead of them. With a minimum spread of 12.5 cents, for instance, purchasing a big block of shares might have been simpler but more costly, showing up immediately in the price. When a price can only go up or down by a penny, there are opportunities for others to jump in along the way.
There’s no such thing as a perfect market structure, and there are plenty of problems and unresolved questions about the way stock trading functions today. We’ve got dark pools and high-frequency trading, which are in the midst of reshaping the market environment in ways we don’t yet understand. "Connectivity issues" that spark trading shutdowns have become frequent enough to spark jokes in the Twitterverse about rogue squirrels nibbling away on cables. Then there are big snafus, such as the one that wreaked havoc during Twitter’s IPO debut.
Regulators aren’t keeping up. Years after the Dodd-Frank Act was passed, it remains unclear how the new rules banning proprietary trading by banks will affect such grey areas as market making, in which financial institutions take positions so that they can accommodate current and future trading needs of their clients.
Nonetheless, for the Equity Capital Formation Task Force the market structure issue on which we all should be focusing our attention remains the minimum “tick size,” or the spread between the bid and asked price.
This is the organization that has been behind some other initiatives, including crowdfunding start-up companies, that it believes will help spark capital formation. By changing the market structure for smaller companies, the group expects that trading activity will increase, market-makers will return to the business of buying and selling smaller stocks (because it will be more profitable) and the enhanced liquidity will attract more coverage from research analysts. That chain of events would make it easier overall for small companies to raise capital in the public markets, or so the argument goes.
Now, I’m not suggesting that there aren’t obstacles confronting smaller companies that want to be public. Yes, it’s hard to get research coverage and to convince a trading firm to make a market in your stock. But I’m not sure that changing the market structure is the way to address them. The problem is far more fundamental.
“If there was money to be made trading old sneakers, Wall Street would be involved,” points out Mike Driscoll, a veteran of Wall Street trading floors, who has seen the evolution of trading from eighths to “teenies” to pennies. “Providing research coverage and making money for those [smaller] companies just doesn’t make money for big banks, and smaller institutions are so lean right now that they can’t afford it.” Nor, he argues, will changing the spreads alter that fact.
Indeed, what Driscoll, now teaching finance at Adelphi University and completing his PhD at the University of Pennsylvania, witnessed firsthand on the trading floor was that decimalization made it easier for his clients – including the mutual funds that the Equity Capital Formation Task Force claims suffered most – to accumulate or sell large positions in small stocks. “The markets were tighter and more liquid.”
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There’s nothing wrong with trying out new trading systems to see if they’ll work, but the reality is that top-down initiatives rarely do work when it comes to the financial markets – and this is one area in which that kind of top-down intervention isn’t really called for, since we’re not talking about protecting the investor or the integrity of capital markets.
The Equity Capital Formation Task Force might be better off focusing on the broader challenges to economic growth (which make businesses and investors risk averse) or to ensuring that new market regulations are structured in as predictable and rational way as possible, to minimize uncertainty among the firms that have the resources to step into the void and commit resources to the world of small and micro-cap companies.
Ultimately, if both the buy side and the sell side on Wall Street don’t think that they’re likely to make money from this space, they won’t commit resources to it. Citigroup (NYSE: C) is interested in test-driving a system under which the tick size of less liquid stocks would be increased, but it will surely lose interest if the pilot program doesn’t prove profitable. (In particular, Citi won’t continue doing so if it finds itself at war with high-frequency traders trying to insist on their right to trade in pennies or even fractions of a penny.)
At some point, if a real gap emerges and there is a strong demand for a better service, someone on a trading desk somewhere will spot it. That person will set up his or her own firm to exploit the opportunity by making markets in illiquid stocks. It has happened before, and it will happen again. That’s what groups like the Equity Capital Formation Task Force should be looking for and supporting.
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