Blog : Tinkering With Tick Sizes

by Ed Zwirn on May 16th, 2014

In the next installment of a major money grab by the securities industry, the SEC may soon decide whether to ask U.S. stock exchanges to enact a pilot program aimed at determining whether wider bid-ask spreads would boost trading in "illiquid" stocks.

According to SEC Commissioner Michael Piwowar, a Republican Obama appointee, if either the exchanges or the SEC itself don't come up with such a program in short order, Congress may soon pass legislation allowing for the widening of tick sizes on penny stocks.

In financial markets, a tick size is the smallest increment by which the price of a stock, futures contract or other exchange-traded instrument can move. SEC rules in effect since 2000 have set the tick at a penny, the so-called decimalization which replaced the fractional quotations of yore.

Proponents at the time argued correctly that being able to bid, say, $1.88 on a stock instead of 1 7/8 would save investors money by lessening the spread (and therefore the money up for grabs by brokers and traders) between purchaser bids and the prices sellers are asking. By computing trades in much-smaller increments than had been the case before, the argument went, there would be less space for the middlemen.

Now, some 14 years later, a move to partially reverse decimalization is making progress in Congress. It turns out, according to the latest rationale, this compression of spreads has actually hurt the liquidity of penny stocks and micro-cap stocks. Turning back the clock, the argument goes, would provide brokerages more money to pay for research and in the process boost interest for illiquid stocks.

As I pointed out earlier in this investment blog, critics of decimalizations also say that the smaller trading increments have mainly benefitted rapid traders and hurt banks and big investors, who they say are discouraged from investing in small companies because the penny increments make it easier for high-speed traders to jump in and beat them out by a cent. 

The so-called Small Cap Liquidity Reform Act of 2013 would force the establishment of a pilot program under which stocks of companies with total annual gross revenues of less than $750 million, must be quoted using either: (1) a minimum increment of $0.05, (2) a minimum increment of $0.10, or (3) the increment at which the securities would be quoted without regard to such minimum increments.

The bill would set procedures under which a board of directors could decide whether to opt in or out of the program and and/or choose among its alternatives.

Congress had directed the SEC to make a study of changes like these when it passed the JOBS act in 2012, and the proposed legislation would cancel the study and move straight to implementation.

With support gaining in Congress for this legislation, or at least some variant of it, it would be preferable for the SEC to act before the politicians decide how such a program is set up, Piwowar said at a Securities Industry and Financial Markets Association (SIFMA) meeting on Wednesday. A number of issues about the pilot need to be decided, he said, such as whether to include stocks in the pilot based on market capitalization, trading volume or revenues, as proposed by the Congressional bill.

Another speaker at SIFMA, Stephen Lurarello, recently appointed director of the SEC division in charge of markets and brokerages, confirmed that the agency would take the bull by the horns and announce its program in the next few weeks.

The upshot for investors: Far from the SEC's asserting its regulatory independence from the politicians, the agency's enactment of this pilot would show just the opposite. The securities regulator, which has had to be dragged kicking and screaming into this questionable initiative, is caving in to political pressure.

And to what end is the SEC being forced to reverse course on decimalization? Even if we accept at face value the premise that brokerages would somehow automatically spend increased profits on value-added research, would more sell-side research actually be a good thing?

Brokerage houses and their often self-interested touting of stocks have been justly blamed as contributors to market downturns and, by extension, the ripoff of investors. Much like the penny stock pump-and-dump schemes that have cheated investors of many millions, the supposedly disinterested recommendations of brokerages have made suckers of many, the difference being not an essential moral or legal one but only that of price.

Whether or not this program actually succeeds in boosting the liquidity of penny stocks, and the data on this is questionable, or it its noble aim of boosting brokerage house research is beside the point. There is big money to be taken from investors if spreads widen. The securities industry is good at stuffing the pockets of politicians, and they wouldn't be doing this costly stuffing if they didn't expect it to pay off big time. Based on that self-evident proposition, it looks like we may soon be ticking off many penny stock prices in nickels and dimes rather than pennies.