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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?

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 is responsible.
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 don’t get ripped off when they trade in shares. On the other hand, smaller firms don’t 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 1990s.
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 infrastructure.”

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