Did Lower Transaction Costs Kill Small Cap IPOs?
The market for small cap IPOs has plunged dramatically. Is the otherwise beneficial trend of lower transaction costs responsible?
By Andrea Burzynski
Cheaper trading in stocks is usually something to be
celebrated. Tumbling transaction costs over the past decade
have benefited the investing public as well as professionals.
Still, there may be a dark side to this otherwise beneficial
trend. As we reported last month, studies show that the
market for smaller IPOs has shrunk in recent years. A
persuasive case can be made that ever greater market efficiency
The basic argument is that thrifty trading has harmed the
old-fashioned brokers, who traditionally helped draw investor
attention to smaller businesses through their research and
sales teams. For advocates of this line, the rot started to set
in with the development of electronic trading in the late
1990s. This started to bring down the cost of transactions by
making trading more efficient. In 2001 brokers suffered another
blow: decimalization in the United States. Instead of fractions
of dollars, stock prices began to be denominated in pennies.
This double blow to profit margins which former Nasdaq
executive David Weild estimates fell by about 96 percent
radically reduced the incentive to deal in the stock of smaller
firms. Without the profits to fund it, research into emerging
firms also declined sharply. This made it harder for investors
to understand startup firms. Instead, it made more commercial
sense for brokers to focus on mega-capitalization stocks, where
huge trading volumes would compensate for meager spreads.
This is the stock market commission paradox, says
Weild. On the one hand consumers dont get ripped
off when they trade in shares. On the other hand, smaller firms
dont get the attention they need from investors. This
means fewer jobs and a less innovative economy.
The move towards low-cost, frictionless trading has shifted the
balance towards investment strategies meant to capitalize
on short term changes in the price of highly liquid, very
large-cap stocks, the Treasury task force concluded in
its October 2011 report. High frequency trading now makes up 75
percent of the volume on U.S. exchanges, compared to 20 percent
in 2004. Emerging growth firms, which typically have very low
levels of liquidity, lose out in this environment.
Chronologically, this theory makes sense. Though the 2002
Sarbanes-Oxley Act is the more conventional scapegoat, the
sharp fall in micro-cap IPOs actually started in the late
Still, other well-intentioned reforms may have also hurt
micro-cap offerings. Some commentators, including Harvard
business professor William Sahlman, believe that efforts to
reduce conflicts of interest at investment banks also reduced
the incentive to cover small firms. The Global Analyst
Settlement of 2003 an accord between regulators and top
securities firms was designed to solve the common
problem of bankers hyping the shares of firms that were paying
them for advice on IPOs and other deals. The settlement aimed
to sever this link by prohibiting compensation of research
through investment banking revenue. This ended up cutting
off another potential source of funding for good research on
smaller firms, says Professor Sahlman. It was also
unnecessary since banks already had an incentive not to promote
investment decisions that cost their clients money. The
solution, Sahlman argues, is to water down the 2003 settlement.
On the bigger problem of trading spreads, Weild proposes an
even bolder solution. Clearly turning back the clock on major
U.S. stock exchanges would not be possible or desirable. Still,
Weild proposes a new exchange focused on smaller firms. A key
part of this market would be that firms could determine their
own minimum bid-offer spreads. A wider spread might deter
investors who simply wanted a quick profit. But longer term
investors would not be put off, Weild argues. In addition, the
fatter trading margins would encourage more research and sales
support from financial firms.
Over the past decade we have destroyed the infrastructure
that supported small firms listed on the stock market,
Weild says. As a result micro-cap firms are no longer
getting the oxygen of publicity and America has lost out on
about 20 million jobs. We urgently need to rebuild this