Bringing Back Real Liquidity

Terry Flanagan

With trading volumes continuing on their multi-year decline, market participants believe there are some measures that can be taken to bring real liquidity back to the markets.

“We need a market structure that brings confidence back to the markets, with real investors providing real liquidity,” said Joe Saluzzi, partner and co-founder of Themis Trading, an independent agency broker-dealer. “The solution is widening the spread and increasing tick sizes. You can have Bank of America and Ford trading at penny spreads and that’s okay, not all stocks need nickel spreads. But the small- and mid-cap names need to have real liquidity providers coming back in.”

U.S. regulators are trying to boost liquidity in smaller-cap stocks, as 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 Barack 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 that increasing the minimum tick size would widen spreads, which would increase the sizes of quotes and in turn increase liquidity.

This would only be enacted if the SEC determines that penny tick increments have hurt small-cap and emerging growth companies’ access to capital.

“Increasing tick sizes is a viable alternative,” said Dennis Dick, a proprietary trader with Bright Trading. “If you look back to when we had fractions, or 6.25 cent spreads, liquidity was thicker because there were 16 price increments. Now liquidity is so sparse, it’s very hard to execute any sizeable order. Increasing tick sizes would help because if you had nickel spreads, you bring all of that liquidity to only 20 pricing increments. You wouldn’t get pennying from internalizers stepping in for one cent or for fractions of a penny.”

At the moment, the markets are going through a period of extended low volatility and low volume, and, because of the current structure, it is likely to continue absent of a catalyst, according to Saluzzi at Themis Trading.

“The current pace the markets are going is unsustainable,” added Saluzzi.

During a conference call with analysts, NYSE Euronext chief executive Duncan Neiderauer blamed declining revenues on reduced high-frequency trading activity. These rapid fire traders are moving into other asset classes in droves, leaving equities behind in the dust. Along with reduced activity from institutional and retail investors, it has left exchanges in a difficult position. Along with an industry that is becoming more fragmented, with over a dozen U.S. venues and countless dark pools, it remains to be seen if the exchange landscape can continue as it currently stands without substantial reform.

“Exchanges recently tried to consolidate and they mostly failed, but even if they succeeded, they would still be fractured,” said Saluzzi.

Case in point, NYSE and Nasdaq each operate three separate trading venues, each with negligible differences aside from pricing. The problem, according to Saluzzi, is that exchanges keep the different venues in order to create arbitrage opportunities, which directly benefit the high-frequency crowd.

“Regulators need to stop approving any new exchanges,” Saluzzi added. “What value does one add over another? They’re each very similar, where can each one go? And why is there maker-taker pricing?”

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