On June 24, 2014, the Securities and Exchange Commission (SEC) ordered national stock exchanges and the Financial Industry Regulatory Authority (FINRA) to craft a yearlong pilot program that requires specific stocks (“Pilot Securities”) to trade in five-cent increments rather than one-penny increments (the “Order”). The Order further directs FINRA and the exchanges to establish a control group and three test groups with specified variables, including one test group with a “trade at” requirement that would allow the SEC to specifically study dark pool trading activity. The Order represents a potentially significant shift for National Market System (NMS) common stocks, and firms should consider whether they will have to make any internal system changes for the Pilot Securities in each test group.
Since 2001, the SEC has sought to evaluate the impact of minimum pricing increments on market participants and the market. According to the SEC, previous studies have indicated that trading at penny increments is disadvantageous for small and midsize companies. Furthermore, Title I of the Jumpstart Our Business Startups Act (JOBS Act) obligates the SEC to study the effect of decimalization on smaller capitalization securities.
The SEC’s Requirements
The Order requires FINRA and the exchanges to collaborate in drafting a plan to implement a one-year pilot program that changes the tick size for small capitalization stocks, and to submit the draft by August 25, 2014. By mandating a minimum tick price of five cents, the pilot program aims to widen the bid-ask spread for lower priced stocks so that the SEC can assess the effect of tick sizes on “liquidity, execution quality for investors, volatility, market maker profitability, competition, transparency and institutional ownership.”
The Order also specifies how the pilot program should be designed. The pilot should be modeled as an experiment with four groups, each composed of 300 stocks. In order to study small and mid-cap companies, the Pilot Securities must satisfy the following requirements: the company must have a market capitalization below $5 billion; an average daily trading volume of one million shares or less; and a share price of $2 per share or more. According to the SEC, the pilot program also should be designed as follows:
- The control group’s stocks should be traded with a one cent per share increment tick size.
- The first test group should have an across-the-board five-cent trading increment. The SEC should be able to compare this group’s trading activity with that of the control group to determine whether a five-cent minimum quoting increment is beneficial.
- The second test group should be the same as the first group, but this group should allow for certain exceptions to the five-cent trading increment requirement. The SEC lists three exceptions where trades should be able to execute at any trading increment: (1) trades “at the mid-point between the national best bid or offer (‘NBBO’);” (2) trades by retail investors that are at least $0.005 better than the NBBO; (3) and “certain negotiated trades.” This group’s trading activity can be compared with the control group and the first group to assess the effect of a minimum quoting increment on liquidity.
- The third test group should be the same as the second group, but this group should include a ”trade-at” requirement. The “trade-at” requirement effectively prevents price matching by trading centers that do not display the NBBO, such as dark pools. In this group, such off-exchange-trading venues can only execute orders if there is a “significant price improvement,” a “significant size improvement,” or to “route intermarket sweep orders” for execution. This group’s trading data can be compared with the other groups to assess whether widening quoting and trading increments results in an increase in trading through dark pools.
The SEC’s Tick Size Pilot Plan has the potential to result in significant changes for trading in NMS common stocks. Firms should assess their internal systems now to determine whether they are positioned to trade the Pilot Securities as the Order mandates.
To read the full SEC order, click here:http://www.sec.gov/rules/other/2014/34-72460.pdf