04.20.2012
By Terry Flanagan

Ax Chops Into Small Cap Liquidity

The electronic trading platform looks to provide liquidity in hard-to-trade, small-cap securities.

“Ax is all about helping people find liquidity that they can’t find anywhere else,” said Kevin Callahan, chief executive officer of Ax Trading.

Ax Trading officially launched in November 2011, and in its five months in operation, it has seen steady growth. Its members traded 1.4 million shares during March, a 23% month-over-month increase. The average executed trade side on Ax was 56,500 shares, and the average market cap of stocks traded on the platform was $1.8 billion.

The trading platform uses an auction system, whereby an order will be sent to the system and there will be five minutes of bidding allowed. Messages get sent to some 250 buy side firms, who can choose to participate in the auction.

“There is latent liquidity that is not being exposed,” added Callahan. “Algorithms are good at finding the liquidity that’s in the marketplace.  But there is a much greater amount of liquidity outside of the market. We think about Ax like a divining rod, which helps you find water underground. The liquidity is there but you can’t see it. Ax is about helping traders find that pool of latent liquidity that’s out there.”

Inherently, small- and mid-cap stocks are going to be less liquid, but regulators are trying to change that.

In order to boost liquidity in small-cap stocks, the Securities and Exchange Commission is considering increasing the minimum trading increments, or tick sizes, on so-called emerging growth companies. The potential new rule is a part of the Jumpstart Our Business Startups, or JOBS Act, recently passed by Congress and signed by President Obama. Aside from job creation and tick size adjustment, the act also aims to increase the amount of emerging growth companies – those with less than $1 billion in annual revenue – going public. The theory is, increasing the minimum tick size would widen spreads, which would increase the sizes of quotes and in turn increase liquidity.

The SEC will have 90 days to report to Congress on the impact of penny trading after the enactment of the JOBS Act. After that, the SEC would then have six months to increase the trading increment for emerging growth companies. That increase would be greater than a penny but less than a dime. This would occur only if it is the SEC determines that that penny tick increments have hurt small-cap or emerging growth companies’ access to capital.

“Expanding tick sizes would mainly help the broker-dealers and market makers, as opposed to the institutional investor,” said Callahan. “It is still very much an open question whether expanding tick sizes would lead to increased liquidity in small-cap stocks and whether it would ultimately help or harm the long-term investor.”

However, there are some participants that believe this controversial proposal would help bring liquidity back.

“Increasing the tick size would certainly be a solution for increasing liquidity in small-cap stocks,” said Dennis Dick, a proprietary trader with Bright Trading. “If you increase the price increments, at the minimum it would stop some of the high-frequency trading firms from the stepping ahead of NBBO (National Best Bid and Offer) for a minimal amount of a penny or less.”

In addition, Dick believes that recently enacted regulation in Canada would improve things stateside. The new rules, also known as the Universal Market Integrity Rules, are comprised of several elements. Visible orders are to have execution priority over dark orders on the same marketplace and at the same price. In addition, in order to trade with a dark order, there needs to be a minimum level of price improvement.

Broker-dealers are also helping to source liquidity for small-cap names as well. Both Goldman Sachs and UBS have each recently introduced algorithmic trading strategies specifically designed for the trading of illiquid, small-cap stocks. Both algorithms use similar strategies, in that they take a wait-and-see approach, sit by idly, and only execute when the opportunity is right and when market impact will be minimal.

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