Wide-Tick Size Pilot Program Enters The Wall St Sausage Factory
First off, we’d like to congratulate to our friends at IEX Trading for a successful launch of their ATS this past Friday. While it’s just the beginning for them, we think that their launch is a critical turning point in the market structure debate. We believe that IEX is the first ATS to actively challenge the status quo with their innovative solution to some of our market structure problems. While we have long hoped for regulators to fix some of the market structure problems, we always felt that regulators would be too slow to act and that the solutions would come from the market.
While we’re thrilled with the IEX launch, we have not yet given up hope that our regulators will decide to finally make some positive changes. One change that seems to be getting more attention is the wide tick-size pilot program. Earlier this month, SEC Chair Mary Jo White indicated she was interested in speeding this along:
“As one step in this direction, I have instructed the SEC staff to move forward on earlier efforts to work with the exchanges as they develop and, if possible, present to the Commission for its consideration a plan to implement a pilot program that would allow smaller companies to use wider tick sizes.”
Our friends, David Weild and Ed Kim, were at the forefront of suggesting that some stocks trade in wider tick increments. Their rationale (which was summarized in their paper “The Trouble With Small Tick Sizes” ) was that wider ticks would create more economic incentive for market makers to add real liquidity to some of smaller and mid cap stocks. We were quite surprised to see that Dave and Ed just picked up one of the large banks as a supporter of the wide tick size pilot program. But being the cynics that we are, we figured that there must a catch. And there was a big catch.
Citigroup published this SEC comment letter saying:
“We believe wider tick sizes would help enhance liquidity and therefore we support a tick size pilot program with such a measurable goal, one that can be evaluated at the end of the pilot program to determine its relative success or failure.”
Citi also said:
“In our view, the most controversial aspect of such a pilot program appears to be the issue of “Quote vs. Trade” – i.e., whether to allow trading at increments smaller than the new, wider quoting increments.”
And here is where the catch comes in:
“Therefore, Citi proposes that any potential pilot program should provide for the ability to quote in wider increments; in addition, it should also allow for market centers to trade at the midpoint of the wider spread; and lastly, it should allow for registered market makers handling retail order sending firms’ orders in the marketplace to trade at various levels within the wider spread, offering an opportunity for price improvement to incoming orders. This is no different than what wholesale intemalizers/retail market makers (such as ATD) do today to provide price/size improvement to retail orders.”
Citi goes on to suggest that the pilot program have three buckets of experimental stocks: 1) One bucket where stocks trade at only the NBBO, 2) one bucket where stocks could trade at midpoint and 3) one bucket where “internalizers” could offer minimal price improvement from the NBBO.
While we are in favor of Citigroup’s first two experimental buckets, we strongly disagree with Citigroup’s third experimental bucket. Allowing internalizers to offer sub-penny price improvement defeats the entire point of a wide-tick program. Wide-ticks are supposed to encourage the display of liquidity and reward the investor who displayed the quote with a fill. Allowing internalizers to jump ahead of displayed liquidity for de minims price improvement would continue to discourage displayed liquidity and harm the price discovery process.
Unfortunately, the wide-tick size pilot program is now entering the Wall St. sausage factory. Just like many other well intentioned rules that we have seen in the past, once the industry starts using their influence to twist them around for their own self-interest, the rule that ends up getting written usually does not bear any resemblance to the original proposal.