The Tick Size Pilot: Key Trading Considerations

This week the SEC begins its test on trading for small-cap stocks. Here’s what investors should expect.

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On Monday the Tick Size Pilot Program, a Securities and Exchange Commission–mandated test widening the tick size of selected small-cap stocks, will officially launch and run for two years. This pilot will affect a group of almost 2,400 stocks that meet the following specifications: market capitalization below $3 billion, average daily trading volume of fewer than 1 million shares and share price greater than $2. Stocks that fit all three criteria account for almost 10 percent of all U.S. equity trading.

Originating in Congress as part of the 2012 Jumpstart Our Business Startups, or JOBS, Act, the Tick Size Pilot had an initial goal to stimulate IPOs and research activity among small-cap 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, brokers 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.

In the final incarnation, the experiment has a few different objectives. First is the stated intent of increasing small-cap liquidity. Proponents believe a wider spread — $0.05, instead of the current $0.01 on exchanges — will lead to more displayed liquidity and thus an easier trading regime. The additional elements of the pilot, namely, trade increment restrictions and so-called trade-at rules, seem to diverge from the primary goal. These add-ons seek to answer the question of whether the proliferation of off-exchange — or dark pool — trading has a negative impact on the quality of the equity market.

The Tick Size Pilot will run for two years, through October 2018. Evaluation will occur throughout, with an assessment on progress after 18 months, and conclude in 2019.

Eligible stocks were randomly assigned to one of four buckets: the control group, which has 1,200 stocks, and three test groups, each with 400 stocks. The control group will see no change to the current trading or quoting rules. Test Group 1 will require quoting in nickel increments. Beyond the first group’s reporting requirement, Test Groups 2 and 3 will have bid, offer and midpoint trading increments. Test Group 3 will be the only group with trade-at capability. (See FINRA’s web site for the full group of affected securities.)

Whereas it will take some time to see the impact of the Tick Size Pilot, here are some points to consider:

This is a big change. For affected companies, this is the biggest change to financial regulations concerning stock trading since the move to decimalization of trading in 2001. It is also a big challenge for traders, as any orders placed at prices in non-$0.05 increments will be rejected. This criterion will require significant changes to trading algorithms and execution and order management systems to adapt to the new rules.

Pilot stocks will be more expensive to trade. Institutional stock-trading costs have been trending down for many years, and we believe that this pilot marks a reversal of that trend. The widening of tick sizes from $0.01 to $0.05 will likely make it costlier for institutional investors to build or liquidate positions in the pilot stocks, despite the pilot intentions. Although it is unclear whether this factor will attract more market making and research coverage to these stocks in the long run, the initial impact is likely to be a drop in available liquidity.

There will be less off-exchange trading in these names. About 37 percent of trading in the tick pilot stocks takes place away from the exchanges, with 22 percent in dark pools. Much of that off-exchange trading for Test Group 3 will not be permitted under the trade-at rule. This restriction could drive more liquidity onto stock exchanges, although it could also cause a near-term drop in overall liquidity for these stocks as traders adjust to the new rules.

Philip Pearson is director of algorithmic trading at ITG in New York.

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