April 11, 2018

Ticking Down

In 2016 to much fanfare, the SEC and the stock exchanges smashed a bottle of champagne on the looming bow of a tick-size study and launched that battleship into the markets.  Two years later the tick study is limping into port in a lifeboat.

For those of you thinking what the heck is a tick-size study, the US stock market is top-heavy.  The weighted average market capitalization of the Wilshire 5000 Total Market Index is $165 billion, yet the median is $1.1 billion.  The market is skewed massively large.  We mentioned these data in our 2014 comment letter on the SEC’s tick study.

Over 90% of the Wilshire 5000’s market cap is concentrated in less than 750 companies – with the bulk of trading volume, inclusion in indexes, Exchange Traded Funds. Seen another way, the Russell 1000 is about 92% of market cap, the Russell 2000, 8%.

The SEC looked across the sea of the market and determined that small caps were marooned in forgotten eddies and byways.  How to remedy it?  Hike the spread.

Historic backdrop is needed to appreciate the irony. Today the market trades in mandated penny spreads, thanks to SEC-led decimalization of markets in 2001.  Why? Back then, many thought intermediary brokers were gouging investors by buying low and selling way too high.

By reducing spreads to a penny, computerized trading systems were able to compete with brokers. The cost to trade plunged.  Regulators cheered their own brilliance.

But sellside research imploded. Without a trading spread to fund cost centers like analysts poring over data and penning reports, the number of firms supporting small stocks with market-making operations tumbled.

The average IPO before decimalization had 66 underwriters, which wrote research on the many thousands of traded stocks. Today’s IPOs have on average six underwriters. Of the 3,500 individual companies comprising the Wilshire 5000 Index, about 2,500 have little or no analyst coverage, and wan trading.

Regulators thought, “Maybe we should widen the spreads?”

When you’re through laughing, I’ll resume the story.

So in 2014, the SEC directed exchanges to run a study grouping stocks – comprising virtually all small caps by our count – in control and variable buckets to see if lifting the spread from one penny to more, such as five cents, would lead to more market-making.  It took two years to hash out details, and the study commenced in October 2016.

The plug will be pulled in October now because the study has produced scant measurable change.  By my reading, market capitalization has become even more concentrated during the study, and the number of public companies continues to shrink.

If wider spreads worked before, why didn’t they work this time?  Four words: Regulation National Market System. Before decimalization, stock markets were not connected to each other electronically and forced to share prices and customers and trade at a single best national price – across all platforms – called the National Best Bid or Offer.

Reg NMS gave us that market. Hike the spread from one penny to five where all trading is still electronic, markets interconnected around the BBO, all you’ve done is widen the step into the same building, and the same behaviors that run up and down the steps – high-speed machines – still set the price.

Nothing has been done to change the economics of brokerage, which still won’t support research.  Plus, rules, not economics, determine spreads.

Suppose you were in the banana business, and you flew back and forth from Belize buying bananas and selling them here. Then the government said you could only make a penny per banana. You cannot predict from time to time if a penny spread on bananas will work for you. And nearer banana growers would put you right out of business.

That is exactly what happened to small caps. They’ve been ticked down to uneconomical. You can’t expect to succeed now as a new public company in US markets unless you land among the thousand largest. The cutoff? About $2.5 billion.

Could we fix this problem? Of course!  But the forces wanting a thousand liquid low-spread stocks to support everybody’s index, ETF, trading, and stock-picking portfolios are powerful.  Until we realize we’ve no longer got a capital formation battleship and it’s instead adrift on a raft, we best love low ticks and big stocks.

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