Are smaller caps short-changed by the stock trading system?
The capital markets have not been kind to smaller companies over the last decade and a half. Shrinking sell-side research, waning market maker capital commitments and a scarcity of engaged buy-and-hold investors is the new reality for many small and mid-cap IROs. Despite high-profile issues like Facebook and Twitter, the steady 15-year decline in initial public offerings has raised concerns in both the US and Europe that lack of market support for smaller companies discourages them from going public and jeopardizes new company startups.
But small and mid-caps still represent important segments of the market. According to data compiled by market intelligence firm Ipreo, nearly 90 percent of all companies listed on US exchanges are below $10 bn in market cap yet account for about half of all trading volume, on average. Institutions own three quarters of the total value of mid-cap stocks ($2 bn-$10 bn) and nearly 70 percent of small-cap stocks ($300 mn-$2 bn), exceeding the 62.5 percent institutional share of mega-cap issues.
No one factor accounts for this state of affairs. Rather, a series of regulatory moves, structural changes and market responses have played against one another to get us to where we are today. One factor often cited is the move to smaller tick sizes – called decimalization in the US – where stocks trade in penny increments and smaller. Following decimalization, average spreads shrank ‘by roughly 38 percent,’ observes Colin Clark, a senior vice president at NYSE Euronext, in written comments to the SEC.
When tick sizes dropped from eighths of a dollar to a penny, it opened a window for traders to step in front of designated market makers, whether on the Big Board or NASDAQ, says one former analyst at an NYSE specialist company. And the net result? Market makers disappeared for lightly traded stocks, while block trades ‘evaporated’.
With the emergence of algorithmic and high-frequency trading (HFT) technologies, it became increasingly difficult for ‘natural’ buyers and sellers (for which, read investors) to find one another, the former analyst adds, requesting anonymity because many of his current trading clients favor decimalization.
Traders who profit from arbitraging market rebates and tiny price moves with lightning-fast execution, repeated over and over, bet on algorithms that use stock tickers like casino chips in a game only a few can play. While every stock trades in this new environment, where up to 70 percent of daily volume can be driven by algorithmic trading, on most days it’s mere noise for larger-cap and liquid stocks. But it can easily dominate daily trading in smaller stocks, discouraging institutional investors, scaring individual investors and frustrating management and IROs.
In Europe, stocks in different markets have faced a complex web of different, and increasingly granular, tick schemes, but change is underway. In 2009 the Federation of European Securities Exchanges introduced a scheme to simplify and ‘harmonize’ 25 different tick-size regimes. Early this year the European Commission released a sweeping set of market reforms, set to be implemented by 2016, that include further limits on HFT. In the US the SEC has been mandated by Congress to look into decimalization and recommend whether a pilot rollback would be useful. Comments submitted to the SEC generally agree the market does not serve smaller companies as well as it did pre-2000. Not surprisingly, however, there is less consensus on what to do about it.
While most observers expect some pilot scheme to be proposed eventually, it will be important to watch three key aspects. Will the SEC choose a random sample of companies or will companies be able to raise their hand to participate and name their own preferred tick size? Will trades in the pilot have to occur at the designated tick sizes, or could market makers step in between? And will the study run for a sufficiently long time to provide useful information through different market cycles, or will it end after a year? Stay tuned.
