On May 6, 2015, the Securities & Exchange Commission (SEC) issued an order approving the National Market System (NMS) plan to implement a Tick Size Pilot Program by the National Securities Exchanges and the Financial Industry Regulatory Authority Inc. (FINRA).
The order, which originated in Congress as part of the 2012 JOBS Act and approved the NMS Plan for a two-year period, finally hit the U.S. equity markets on Oct. 3, 2016.
The Tick Size Pilot program is a data-driven test to evaluate whether or not widening the tick size for securities of smaller capitalization companies would affect trading, liquidity and market quality of those securities. The pilot consists of a control group and three test groups, with each test group having approximately 400 securities.
The Tick Size Pilot affects all stocks with a market capitalization under $3 billion with average daily volume of less than one million shares. There’s a control group and three test groups that were announced on Sept. 2, 2016. More than 40% of tick pilot symbols have average spreads under 5¢, and more than 30% of trading in tick pilot names occurs at prices that will no longer be allowed in Test Groups 2 and 3.
The stated goal is stimulating IPOs and research activity among small-capitalization companies in an effort to create jobs. The theory is that by increasing the incentives to make a market in these stocks with wider spreads and less volatility, banks will be more likely to provide research and underwriting for small companies. This effort has morphed into a broad experiment on U.S. equity market structure.
“The purpose of the pilot is to determine if widening the tick increment will improve liquidity, reduce volatility and generally increase the market quality of trading these selected securities,” says Philip Pearson, Director, ITG Algorithms, who co-wrote a white paper on the matter called “Tick Pilot 2016: Make Small Caps Great Again.”
In the final incarnation, the experiment has a few different objectives. First is the stated intent of increasing small-cap liquidity. Proponents say a wider (5¢) spread will lead to more displayed liquidity and thus an easier trading regime. The additional elements of the pilot, namely trade increment restrictions and “trade-at” rules, seem to be unrelated to the primary goal.
The focus of these add-ons is whether the proliferation of off-exchange (dark pool) trading has a negative impact on the equity market quality.
As ITG and many other market participants argued, the complexity of the project dilutes the original intention.
This is not just a tiny corner of the market. While individually these stocks are illiquid, in sum they add up to about 11% of all U.S. equity trading. That’s more than 600 million shares trading per day. It’s time to get ready. Now, traders, exchanges, market makers and other industry participants are racing to get the infrastructure in place to accommodate the new rules.
Smaller cap securities generally have less liquidity provisions by market makers than larger cap companies. The smallest 4,721 securities account for just 22% of all trading volume, while the largest 500 securities represent 61% of trading volume.
“The Tick Size Pilot’s initial goal was stimulating IPOs and research activity among small-cap companies in an effort to create jobs,” Pearson says. “The theory is that by increasing the incentives to make a market in these stocks with wider spreads and less volatility, brokers will be more likely to provide research and underwriting for small companies. It is too early to tell what the actual result of the pilot will be, but we did some research on the matter.”
To study the effect on all 3,100 tick pilot stocks, ITG looked at the first quarter of 2016. To improve the data quality, ITG made a few changes: First, the firm removed any stocks that were trading under $2. Those are not eligible for the pilot. Second, they removed stocks with ADV < 10,000. While these stocks will be eligible, they skew the data (10% spreads) in a way that could cause misleading conclusions. This left them with a sample of 2,575 stocks.
The average stock in the pilot program has a price of $23, an average spread of $0.11 and average daily volume of 343,000 shares. However, that average spread is quite volatile. The question of how the spreads of these 2,500+ stocks may vary is particularly fascinating, Pearson says.
ITG looked at the spreads of all pilot stocks over the course of the day in 15-minute buckets. Trading cost analysis has repeatedly shown that trading costs are lower as the day goes on. Spreads are significantly lower toward the end of the trading day. Less than 10% of all pilot stocks had a spread < 5¢ in the first 15 minutes of trading. This number rises precipitously over the course of the day, ending with more than 75% with tight spreads in the last bucket. This indicates that the tick pilot will have a more dramatic effect later in the day when prices are more established and volatility has dampened.
Another way to look at it is by volume rather than by time. For the whole sample, looking only at executions, 47% of shares traded took place when the spread was less than 5¢. This compares with 41% of the total time (of the trading day) when stocks were quoted in that range. This could be for two reasons: Trading patterns mimicking the above spread chart (more trading later in the day when spreads are tighter), or potentially narrower spreads causing more trading as demand and supply are closer in line.
One way to see how the tick pilot might change trading patterns is by splitting the stocks into two distinct groups: stocks with average spreads below 5¢ (small- spread group) and stocks with average spreads above 5¢ (wide-spread group). Theoretically, not much will change with the latter group while the former faces an impending structural change.
“Splitting the difference” (below) shows the simple averages of each of the 2,575 symbols that we studied. We were surprised to see that 42% (1,083) of the stocks actually had average spreads less than 5¢. The average price of the small-spread stocks was lower, $13, compared with over $30 for the wide-spread group. Interestingly, the average spread of the small-spread stocks was significantly lower in basis points, 21.6 bps vs. 57.8. Large-cap stocks typically see low-priced stocks with larger spreads in basis points due to the minimum tick size of 1¢. This did not seem to hold for small caps. This is likely because these companies are less liquid. Also, it is definitely worth noting that the small-spread group had higher volume in both shares and dollar terms.
For affected companies, this is the biggest change to financial regulation concerning stock trading since the decimalization of trading in 2001, according to Pearson. It is also a big challenge for traders, as any orders placed at prices in non-5¢ increments will be rejected.
“This will require significant changes to trading technology workflow to adapt to the new rules,” he says.
In a statement, the New York Stock Exchange has said this pilot program will be a positive first step in determining how small caps can attract more liquidity in the trading of their shares.
The New York Stock Exchange published a list of eligible securities for inclusion in the data collection phase of the tick pilot. Tick pilot eligible securities are Common Stock Operating Companies (excludes ADRs, closed-end funds, preferred stocks, warrants, units, structured products and exchange-traded products).
At least initially, pilot stocks will be more expensive to trade, according to Pearson. “Institutional stock trading costs have been trending down for many years, and we believe that this pilot marks a reversal of that trend,” he says. “The widening of tick sizes from 1¢ to 5¢ will likely make it costlier for institutional investors to build or liquidate positions in the pilot stocks, despite the pilot intentions.”
It is not clear whether these wider spreads will attract more market making and research coverage to these stocks in the long run, but the initial impact is likely to be a drop in available liquidity.
You can learn more about which markets are affected at finra.org.