SEC Orders Tick-Size Pilot

Terry Flanagan

The Securities and Exchange Commission has ordered the national exchanges and the Financial Industry Regulatory Authority to submit a national market system plan by August 25 detailing a pilot program for nickel-size tick increments in an effort to boost liquidity for small and mid-cap stocks.

The pilot will consist of three test groups with 300 securities in each. Securities must have a market capitalization of $5 billion or less; an average daily trading volume of one million shares or less; and a share price of $2 per share or more.

Some observers question the need for such a pilot.

“We believe that ultimately the markets should always benefit the end investor,” William Baxter, head of global program trading and market structure at Fidelity Investments, told Markets Media. “Generally, we are in favor of pilot programs that take a data-driven, empirical approach. But we’re skeptical that a change in tick size for small-cap stocks will benefit retail and institutional investors.”

Pilot securities in the first test group will be quoted in $0.05 minimum increments, with trading continuing to occur at any price increment permitted today. Pilot securities in the second test group will be quoted in $0.05 minimum increments, and traded in $0.05 minimum increments. Pilot securities in the third test group will be subject to the same minimum quoting and trading increments as the second test group, but in addition would be subject to a “trade-at” requirement preventing price matching by a trading center that is not displaying the best bid or offer.

Small-cap stocks do have less liquidity, but not because of tick size, Baxter said. For instance, it could be because only a few investors hold most of the available shares, or there are only a small number of shares outstanding, or the stock may have very low correlations to other securities or instruments.

Decimalization of the U.S. equity markets occurred more than a decade ago. Prior to decimalization, the minimum pricing increment had been 1/8 of a dollar (12.5 cents) and 1/16 of a dollar (6.25 cents). Since decimalization, the nature of trading, the structure of the markets, and the roles of market participants have changed significantly.

The pilot program should facilitate studies of the effect of tick size on liquidity, execution quality for investors, volatility, market maker profitability, competition, transparency, and institutional ownership, the SEC said.

“A robust pilot program will generate critical data for assessing the impact of wider tick sizes on the securities of smaller issuers,” said SEC Chair Mary Jo White, in a statement. “It is time for a careful assessment of the impact of decimalization on our equity market structure and the interests of investors and issuers.”

Minimum pricing increments are important because they affect the nature and extent of displayed liquidity in a stock as well as the transaction costs of investors and others when they seek to access displayed liquidity.

“Pilot programs have clearly become a useful tool to evaluate changes to market structure,” Baxter said. “But as an industry, we must continue to work with regulators to create metrics, measure any changes in the market, and define the overall success of these programs.”

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