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This could be a game-changer for small-cap stocks

Saturday, 16 Nov 2013 | 9:00 AM ET
File Photo: Nighttime view of the neon financial ticker on the Morgan Stanley headquarters.
Oliver Morris | Getty Images
File Photo: Nighttime view of the neon financial ticker on the Morgan Stanley headquarters.

A significant change on its way for stock trading could bring nickels and dimes from heaven for smaller companies.

After 12 years of trading stocks in penny increments, a proposal is afoot to change the system so that firms with market capitalizations less than $750 million could be listed in nickel and perhaps even dime or quarter increments.

Advocates see the proposal—pushed both by major exchanges and in a recent letter Citigroup sent to regulators—as increasing liquidity in the lesser-traded names. Since the market switched to decimal trading in 2001—away from fractions—market makers have stayed away from the smaller names because the trading spreads between the buy and sell prices were too small.

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But with larger increments would come larger commissions, which in turn would drive market makers toward those companies and bring greater liquidity to the market, supporters say.

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"Seeing volume return to the New York Stock Exchange would be very positive," said Peter Costa, president of boutique trading firm Empire Executions and an NYSE governor. "We want to do what's in the best interest of our business model, but in essence our best interests are also pretty much aligned with those of institutional investors."

Under the present system of stocks listed in penny increments, high-frequency traders have flourished—and have been blamed for some of the market's woes.

The HFTs use computerized algorithms to detect mispriced stocks and use speed to execute trades in fractions of a second. Their trading risk is minimized by the small increments between prices, something Costa said would not be the case with a nickel system.

Supporters concede that part of the push to go to higher ticks is a recognition that the move to decimalization was not a complete success.

"There are very few high-frequency trading shops that are going to be in existence," he said. "Their risk is not going to be a penny or less than a penny. It's going to be four cents-plus. They haven't developed a model where they can afford that risk."

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To be sure, the proposal has its critics.

They worry of the risks associated with trading smaller amounts of stocks and doubt supporters' claims that increased trading in smaller stocks would push profits back to those companies that they could reinvest in growth.

David vun Kannon at market blog Rational Exuberance painted a scenario in which smaller companies would be cajoled into agreeing to nickel ticks with the incentive of a bigger price on their initial public offerings. That price, he said, would be passed onto retail investors.

I can imagine that if the wider tick size rules go into effect, that the conversation will go like this:

Banker: If you agree to have your stock traded in nickels, we'll price your IPO $50 million higher.

Management: I lose nothing and get $50 million, sounds like a good deal.

Well, the bankers are not a charity. That $50 million is going to come from somewhere. Enter the retail investor!

Invoking job creation at small companies is just putting lipstick on the pig. Wider tick sizes enriches the market maker at the cost of somebody else. The bankers and markets are bribing the managements to go along.

To be sure, proponents believe that the changes will need to be approached with caution.

Citi's letter to the Securities and Exchange Commission advocated a "pilot program" with a set time frame and evaluation period at the end.

"In some cases, increasing the minimum quoting increment from a penny to a nickel makes sense; in other cases, increasing the increment to a dime (depending on average daily volume traded and stock price) or even a quarter (particularly for very high­ priced securities) may be warranted," Daniel Keegan, managing director and head of equities for the Americas at Citi, wrote to the regulators.

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"One of the outcomes of a potential pilot programs should be to create objective standards for determining the appropriate quoting increment for particular types of securities," he added.

Costa said it's likely that even if the changes do meet their objectives, they likely never will be extended to large-caps. Keegan said trading in the big names "seems to be functioning well."

Peter Andersen, chief investment officer at Congress Asset Management in Boston, said he supports going to larger ticks but would go along with the program only as a pilot.

"It's hard to strip out how much of this might be motivated by company policy and revenue enhancement vs. the true altruistic effort of trying to promote liquidity and make us all much happier people and trading place," he said. "The only way to prove this is to actually do it."

He expects smaller companies to get more trading traffic while those involved in trading have an easier time of moving in and out of positions, ultimately providing benefit across the board.

"We think this is going to be better for everybody," Andersen said. "I wouldn't think this if it was not proposed as a pilot program."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.

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