After four years of debate, all the major exchanges will begin a pilot program Monday that will allow 1,200 small-cap stocks — more than a quarter of the market — to trade in increments of a nickel rather than a penny.
The reason? Trading in small-cap stocks has declined for years as the biggest stocks get all the attention. The trading community wants to see if trading in increments of a nickel will create more volume and more interest in small cap stocks.
Will it make a difference, and why is trading in small cap stocks dying?
The so-called Tick Size Pilot (TSP) has been mired in controversy for years. Most of the trading community seems to hate it. It's not because they don't want to see more trading in small-cap stocks. Everyone wants that.
It's because they've spent a lot of money to do this pilot and it's not at all clear it's going to make any difference.
Here's the theory: Trading in small-cap stocks has been dropping off for years. Partly this is due to the big drop-off in IPOs in the last several years.
Partly it's due to the fact that the analyst community is far smaller than it was a decade ago, so a lot of stocks simply wither for lack of coverage. Partly, it's because the major indices are all market-cap weighted, so the bigger stocks (the largest 500, and particularly the largest 100) get the most volume and attention. Everything else languishes.
They theory is that letting traders trade in nickel increments rather than pennies will allow them to make deeper markets. Simply put, they'll have more chance to make money around a nickel than around a penny, which hopefully will create more liquidity. That might make market makers more willing to hire analysts to provide more coverage.
That is the theory. The problem is, a large part of the Street doesn't think it holds water.
"I'm skeptical this will make a difference," Eric Noll, CEO of Convergex, told me. Noll is a long-time authority on market structure and a member of the SEC's Equity Market Structure Advisory Committee.
The big issue is a lack of enthusiasm, not a lack of liquidity. Big institutions already know how to access liquidity if they really need it.
One reason they trade less is that there is often nothing very interesting to buy. Another problem is sheer size. Small-cap companies by definition have market capitalizations below $3 billion, but many can be below $500 million. An institution that would want to put, say, $50 million to work would own 10% of a company with a market capitalization of $500 million. That's too much ownership for most institutions.
Then there's the cost. A lot of time and money has been invested, and it's not clear this will increase volume or that it will be worth it even if it does increase volume.
How do the listed companies whose shares will be trading in a nickel feel? I am not aware of any survey. Strange, no?
What will this mean to the average retail investor? For the 1,200 stocks in the pilot, the retail trader will see bid-offers only with nickel spreads.
However, retail investors will be able to get price improvement at the penny or even sub-penny level, so retail traders should still see trading in pennies, even if he or she only sees bid offers in pennies.
It's the institutional traders — that means the Fidelities and Vanguards and pension funds — that will pay a nickel.
The pilot will last two years, at the end of which they will determine if there is any increase in trading and will make recommendations to make this permanent. Or not.
Of course, everyone agrees that they would like to see more volume spread out across more securities. But it's not clear how to do that.
A more robust IPO market would certainly help. And perhaps less emphasis on indexes that use market cap weightings as the sole criteria would help as well. This is what's behind the whole "smart beta" movement with ETFs to find other "factors" that are worth using to weight stocks.
Here's the broader question: Why does it take the SEC four years to get a pilot program together? Because there are too many interested parties, and the bureaucracy is too big. What we need are advanced technologies to test these programs in an artificial environment that accurately mirrors the real world.
We need big data analytics applied to billions of trading records.
Calling Google!
Addendum: For those who want the details, the program dumps the 1,200 stocks into three "buckets" and a control group:
1) a control group of 1,500 stocks that will continue to trade in pennies.
2) a bucket of 400 stocks, that are only quoted in nickels but can trade in any increment, including pennies So the only thing changing is the quote.
3) a second bucket of 400 that can be traded in nickel increments, so if you have a stock with a bid of $10.00 and an ask of $10.05, the next price it can be bought is at $10.10, not $10.06. So both the quote and trade change. Retail investors will be exempt.
4) the third bucket of 400 stocks has the same requirements of 3), but will add a "trade-at" rule. This means that you can trade at the National Best Bid and Offer (NBBO) when you are part of an exchange, but dark pools and other "dark" venues must provide price improvement. In other words, "lit" markets (stock exchanges) will have priority over "dark" markets (dark pools).