Fred and Ethel Are Confused About Sub-Pennies and Locked-Zero-Width-Markets. Or Are They?



We were called the day before yesterday by two very dear friends of ours, Fred and Ethel Bonerainvestamente. They heard about a discussion on tick sizes about to take place at the SEC, and were confused.  Note that Fred and Ethel have been model students of our modern markets in the last few years – they have read Broken Markets, Dark Pools, and even The Problem With HFT, which we sent them a few weeks ago. They asked us to stop by and clear up a few things for them, and we obliged yesterday evening.

TT:       So guys, what’s on your minds? You seem upset or worried, especially for investors who just saw 14,000 on the DOW. You should be happy!

FE:      Do we look like cattle to you, son? Pipe down. We didn’t get to live this long by listening to lines of horsedung spewed by you smart MBA boys. We want to talk to you about this tick size thing.

TT:       Oh, you mean the SEC having a roundtable discussion to have wider minimum spreads in small cap stocks? It makes sense for them to experiment like this, no?

FE:      Yes we think so. We liked that chapter in your book by that David Wield fellow. Penny spreads flipped back and forth by machines does not make a helluva lotta sense to us for smaller companies. Because the real market makers aren’t there anymore.

TT:       Yeah. Right on. In smaller cap companies, while we might see some small spreads, the market is hollowed out. There is no support by small research firms, who would derive compensation by making markets in these small names. I will wager a guess that there will be a pilot program that requires a wider tick size in these companies. JOBS ACT and all of that. I bet we see it this year. I don’t know if it will work, but we need to bring back pilot programs to at least try to reverse some of the foolishness of the last decade.

FE:      You know what? What you just said makes sense. We heard the same thing come out of the mouths of every major stock exchange over the last few weeks. And even some of those Freak firms. So our radar is up. That scares us. I feel like all you MBA boys want us to look at your right hands, while your left hands are busy with something else.

TT:       Fred… Ethel… You are being way too cynical! We think the exchanges want to change. We even heard some of them use words like “holistic change” and “do-over” in the past few months.

FE:      We are surprised at you boys. Here Read this BATS letter from January 29th.  This is why we are nervous. They want to have less than 1 cent spreads? They want to have locked markets too. This is why we called you. Help us out. What’s the deal with this letter, and with locked markets? It seems like they are using the SEC’s willingness to look at tick sizes, and  are using that as an excuse to try to make them smaller! We are confused and were hoping you might explain what’s going on.

TT:       Well I think the crux of their argument is that spreads can be even narrower for you two. If you are buying, let’s say, 300 shares of a $35 large cap stock with a 1 cent spread, they believe you could benefit from a ½ cent spread, or even a zero spread.  You could have lower costs! On a $10,000 purchase they think you potentially can save $1.50.

FE:      Is this a joke? They want to save me $1.50 on a $10,000 purchase? They care about the spread I pay? I don’t buy it. I am surprised at you MBA boys. Besides, those spreads change every instant and are meaningless. Our markets are order-driven – we learned that from your book. And when we buy or sell a stock we could give a rat’s tookas what the damn spread was – we know the price we want to pay and just use that price. I don’t like when people use us as a reason they want to change things – last time they did this they created the damn fragmented broken market structure.

TT:      Well, I suppose it might have something to do with their largest high frequency trading customers, who are seeking rebates. Maybe allowing zero-width markets would allow them to pump more volume through the exchanges. Maybe there might be new games and optimization algos that aid in maximizing the high speed firms’ rebates. Maybe that would drive the need for more speed, and make buying colocation space from the exchanges even more critical. Maybe it would create more market data revenue? Maybe even the exchanges feel that having locked zero-width markets, and ultimate narrow spreads, would take away some of the volume that is trading in the dark in sub- pennies away from them – that percentage has exploded to north of 35%!

FE:      Wait a minute. Haven’t spreads in the largest companies already fallen from about 2 cents to 1 cent in the past 10 years, and haven’t spreads actually gotten a little bit wider in the last 4 years or so? What’s the deal with that? What happened to dark volume over this period?

TT:       Well… umm… like we said it exploded.

FE:      And they think narrowing it further will make it go the other way? That’s dumb.

TT:       You know what, Fred and Ethel, you are right!

FE:      And another thing. What good is a bid at 50 cents and an offer at 50 cents, at the same time, where they don’t trade. There is no clearing price. Won’t that affect the most basic economic principle of supply meeting demand and setting clearing prices? Won’t that have effects on stock prices where quotes are divorced from trade interest?

TT:       Yes… you mean price discovery. You know what guys? You are on the ball. You are right. We are idiots for not seeing this point of view earlier. And we should have. After all BATS, NASDAQ, and NYSE were trying to lower the tick sizes for many years. They actually wrote a petition to the SEC in April 2010, but that was before the Flash Crash, and that kind of died. I guess they now feel with the DOW hitting 14,000 that the dust has settled, and the JOBS ACT stuff is a good excuse to try to raise this issue again. Thanks for setting us right!

FE:      Well it’s nice that you understand it. But what we really hope is that the SEC understands it.