SEC Rethinks the Penny Tick in Stock Trading

Jim Watson | AFP | Getty Images

Remember when stock market regulators ditched fractions and started rounding to the nearest penny? Well now, regulators are reviewing the move to see if it still makes sense.

The Securities and Exchange Commission on Tuesday will host a roundtable to review the move to decimalization, which was basically the introduction of the metric system for the stock market after more than 200 years of using fractions.

The move from fractions to decimalization didn't happen overnight: Beginning in the 1990s, the SEC began a campaign to undermine the old system. At first, the SEC helped push through changes at the exchanges that lowered the minimum tick size from 1/8th of a dollar to 1/16th, and later to 1/32 of a dollar. The market makers and other Wall Street types were making too much money on the spreads, the SEC argued. Push down the tick sizes and you'll make markets more efficient and fairer for ordinary investors, the argument went.

By April 2001, decimalization was the rule at every stock exchange. A further rule pushed the "tick"—the minimum price change for bids and offers of shares—down to one penny. This has been the pricing rule for stocks ever since.

Some of what the decimalizers wanted has been accomplished. Markets have moved toward becoming more liquid, frictionless, and heavily electronic. The hated market makers and specialists have been nearly driven from sight.

Perhaps not surprisingly, the story of decimalization doesn't stop at these accomplishments. A paper released by Grant Thorton in 2009 described decimalization as a "death star" for U.S. equities markets, adding that it had eliminated nearly all of the economic incentives for trading in small-cap stocks.

A task force formed in March 2012 found that decimalization had created an environment that favored the stocks of companies with highly liquid, very large capitalizations at the expense of smaller companies. In other words, once again, a rule that was created to favor the "little guy" or "ordinary investor" wound up giving big businesses an advantage over smaller businesses.

The market changes not only biased the system in favor of big companies, they biased it in favor of short-term rapid trading over long-term fundamental investing. So high-frequency traders dealing in highly liquid large caps get a boost, while long-term investors who want to "do their homework" are penalized. Not exactly what we were promised when the tick went to a penny.

The task force also found that the IPO market for smaller companies had been badly hurt by decimalization. The lack of traders using fundamental strategies to trade smaller stocks made them less appealing to the trading desks of investment banks, which in turn made investment banks less desirous of underwriting IPOs. Analyst coverage shifted away from smaller stocks to larger ones, in part because of the effect of decimalization on trading and in part because of the global analyst research settlement of 2003. Less coverage and fewer companies coming to market further diminished market interest in these stocks, the task force argued.

In April 2003, Congress passed the JOBS Act which ordered the SEC to examine the effects of decimalization, particularly with regards to small-cap trading and IPOs. The report from the SEC was, well, highly inconclusive. The SEC reviewed the academic literature on decimalization and concluded that "though there is literature on the types of benefits that lower spreads bring to the market, there is less available information related to how lower spreads may have negatively impacted capital formation, especially with respect to the complex, competitive dynamics and economic incentives of market intermediaries who provide liquidity."

The SEC's report concludes that there just hasn't been enough research done to isolate the impact of decimalization from the impact of other market changes. This isn't surprising. It's very hard to isolate the impact of one regulatory change from another. Each one likely feeds on the other. Was it Sarbanes-Oxley? Or the Global Settlement? Or Reg NMS? Or decimalization? The answer is probably: yes.

Perhaps the lesson of this is that long-evolving market practices aren't easily understood by regulators, which means that regulators are unlikely to anticipate the consequences of forcing changes on those practices. What's more, the regulatory superstructure itself is so complex that its hard to anticipate how one reform will interact with the existing body of regulations—much less regulations that haven't yet been put in place.

There will be three panels Tuesday. The first will center on the impact of tick size on small- and medium-cap companies. The second will center on concerns about the broader market. The third on possible alternatives to tick sizes.

There is not a panel on the limits of the ability to regulators to understand the consequences of their attempts to improve the world.

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