SEC Approves Two-Year Tick Size Pilot
SEC Approves Two-Year Tick Size Pilot Jun 2015
The Securities and Exchange Commission voted unanimously on May 6 to implement another component of the Jumpstart Our Business Startups (JOBS) Act by approving final rules of the tick size pilot program, including expanding the program’s term from one to two years. The pilot will widen the minimum price at which some stocks for small cap companies are quoted on exchanges in order to study its effects on liquidity and broker-dealer support. Proponents of the pilot had pressed the agency to expand the length of the program to increase participation by EGCs and broker-dealers.
Exchanges must start the pilot program by May 6, 2016. The SEC will allow 1,400 companies with market values under $3 billion and average daily trading volume of less than 1 million shares to participate. The companies must apply to participate in the pilot program.
The program would reward brokers for making markets in less-liquid stocks by increasing the amount or “spread” they earn when buying and selling shares. The SEC said they revised certain data elements from the original plan concerning market maker profitability to make the data collection less burdensome and assure the protection of confidential business information.
"The SEC, through hard work and appropriate diligence, crafted an effective and robust tick size pilot. I believe that the SEC's modifications to their preliminary proposal will significantly enhance the meaningfulness of the Pilot Program,” said Stephen Holmes, partner and COO at venture capitalist firm InterWest Partners in an email to Growth Capital Investor. “The result of their efforts is one of the most promising initiatives undertaken by the SEC in recent memory to bolster the liquidity environment for small capitalization companies. I believe the SEC’s action will prove to be a real victory for the entrepreneurial ecosystem, the American economy and the creation of attractive jobs.”
The agency plans to study the pilot program to assess whether wider tick sizes enhance the market quality of these stocks for the benefit of issuers and investors. “The data generated by this important market-structure initiative will deepen our understanding of the impact of tick sizes on market quality,” SEC Chair Mary Jo White said in a press release. The SEC gave the exchanges have one year to get their trading systems ready and hire additional people if needed, giving the pilot a start date of May 6, 2016.
When the tick size pilot was announced last year there was outcry from creators of the plan, including David Weild of Issuworks, that a one-year pilot would not be enough time to measure the pilot’s effectiveness in helping emerging growth companies. Weild also opposed the $5 billion market capitalization threshold the SEC had originally planned because he believed not enough small companies would be included in the pilot.
Congressman Duffy told Growth Capital Investor last year in an interview that he’d make a hard push to get the SEC to lengthen the pilot to at least two years. The tipping point came early this year when two senators who are on a committee that influences the SEC budget joined with Congressman Duffy. Senators Pat Toomey and Mark Warner held a Senate subcommittee hearing on March 17 that included marketplace leaders testifying to the impact on emerging growth companies that a change in tick size would have. Additionally, a new congressman from San Diego, Congressman Juan Vargas, went to Silicon Valley to learn from venture capitalists how investing in emerging growth companies works and the challenges these start-up companies face. A week later he was writing letters to support the tick size pilot according to Holmes, who met with Congressman Vargas.
“I’d also like to congratulate Congressman Duffy for his successful realization of his proposal, and thank Senators Toomey and Warner and Congressman Vargas for their leadership on this issue,” Holmes told Growth Capital Investor.
The SEC’s Investor Advisory Committee voted 13-3 in January 2014 to not conduct the pilot program. Holmes is a member of the Committee. The SEC ignored the vote and with a push from Congressman Duffy went ahead and ordered the stock exchanges and FINRA to come up with a plan to implement system changes for trading in five-cent increments. Opponents of the plan, including Fidelity Investments and D.E. Shaw, were against the tick size increase because they thought investors will have to pay more to buy and sell shares of small companies.
In the last year there was a huge lobby effort by the exchanges and alternative trading platforms, including NYSE, NASDAQ, and BATS, to exempt alternate trading systems and private trading at large investment banks from the program. These exchanges included.
There are four groups of stocks with different market parameters in the pilot. In the third group the SEC is mandating the “trade-at” provision, with the idea that this will test whether price and execution quality improves if more orders are routed to exchanges instead of alternate platforms.
The trade-at provision is intended to improve “displayed liquidity” and order depth at the NBBO (National Best Bid and Offer). Trade-at prevents a venue from executing a trade without also quoting at the NBBO.
“The major stock exchanges (NASDAQ and NYSE) have wanted a ‘trade-at’ rule to counteract the dark pools who they see as parasites draining orders away from the stock exchanges by leveraging the NBBO on the exchanges as their ‘reference price’ to provide trivial price improvement (say, down a 10th of a penny, undercutting the NBBO),” David Weild former Vice-Chairman of the NASDAQ told Growth Capital Investor.
Brokers who use private platforms see it differently. Cromwell Coulson, CEO of OTC Markets Group, an ATS that is a network of brokers, told Growth Capital Investor, “I like the five-cent increase in tick size for emerging growth companies to hopefully help raise equity capital but don’t like the trade-at provision. It feels like the pilot became a lets-protect-the-exchange model.”
When the SEC final vote was announced Bloomberg noted that the exchanges had sought restrictions on dark trading for years as their share of trading dropped to about 64%. The SEC said another change made in the final approved plan is they will reduced the size of block transactions eligible for the exception to better reflect trading in smaller-cap stocks
“The average order size in stock markets today is said to be under 200 shares. Market makers take 100,000 share blocks and push them through ‘electronic wood chippers.’ The lower size is intended to get more firms to experiment with block liquidity – it expands the total addressable market since the number of large block orders is very small but large block orders can be parsed into 5,000 share (or larger) increments,” Weild explained.
Additionally, the SEC removed the venue limitation from the trade-at prohibition that would have required price matching executions to occur where the person’s quotation was displayed. This change will allow a venue to execute anywhere (for example, a market sweep order) as long as it is quoting at NBBO. This was likely a concession by the SEC to market makers to be able to execute trades more broadly on their own or other venues.
Coulson worries about how the hidden liquidity market makers use to help move trading volume in stocks will be affected. “With this pilot you can lose competitive market maker liquidity at the touch and instead there will be more tail trading,” Coulson said.
The SEC will allow shares in stocks in the three other test groups to trade off-exchange at alternative trading systems like the OTC Markets but it is unclear how many companies will be in those control groups. According to OTC Markets, there are approximately 6,685 companies with a market capitalization below $3 billion trade on the OTCQX, OTCQB and OTC Pink marketplaces.
“If the SEC ensures that market makers (Exchanges, ATS, ECNs and Dealers) are excluded from the control group if they don’t participate in the test groups, then the pilot will yield results that will inform market structure for years to come because there will be a valid basis of comparison between the control and test groups. If the SEC allows market makers to participate in the control group but not the test groups, the pilot could yield garbage – for me, this is the last remaining question,” Weild told Growth Capital Investor.