New SEC Data Proves What We Already Knew: Small Cap Spreads Are Wide and Liquidity Is Scarce


The SEC has just published a data-driven study on spreads and liquidity titled “A Characterization of Market Quality For Small Capitalization US Equities” .  Most of you who trade regularly will not be surprised to learn that the study finds that spreads are wide and liquidity is scarce in most small cap stocks.

A few things about the study before we get into the results:

– The SEC used MIDAS data collected from the exchanges for all of 2013.

– The data is time stamped to the microsecond and covers 2814 stocks with market cap of $5 billion or less.

Now for the results according to the SEC:

During 2013, US-listed, US-domiciled small cap stocks with capitalizations below $1 Billion were much less liquid than stocks with capitalizations between $1 Billion and $5 Billion. Small cap stocks had larger quoted and effective spreads and traded much lower volumes than mid cap stocks. They also showed lower depth at the inside quotes and beyond. Liquidity improved with market capitalization: the smallest stocks with capitalizations below $100 Million exhibited the least liquidity and mid cap stocks with capitalizations between $2 Billion and $5 Billion exhibited the greatest liquidity.

Median quoted spreads range from 6.22 to 113.52 cents for the smallest stocks and from 1.00 to 5.77 cents for stocks with capitalizations between $2 Billion and $5 Billion.

 – On average, the smallest capitalization stocks have much less displayed size at all levels of the order book when compared to larger capitalization stocks

 – Small capitalization stocks exhibit much less depth than stocks in the $2 to $5 Billion capitalization range. The smallest stocks (< $100 Million capitalization) exhibit displayed depth on the order of 0.2 to 1.1 per cent of the depth for similarly priced stocks in the $2 to $5 Billion 

– Many small capitalization stocks exhibit very little depth at 1, 2 and 5 cents away from the midpoint.  (Themis note: one caveat to depth examples which makes this data even worse is that much of that depth often disappears when the top layer of quotes are accessed).

This data-driven SEC study finally debunks the false claims that high frequency trading shrinks spreads and adds liquidity in the stock market.  The study reveals that once you get past the most active stocks, most other stocks trade with wide spreads and with very little liquidity.  The study also reveals the secret that most defenders of our current market structure would rather you not know – our equity market has been hollowed out.  Beneath the hard shell of actively traded stocks that  trade with penny spreads exists a soft core of stocks that rarely trade and are often overlooked by many investors (over 75% of the stocks in the Russell 2000 Index have less than 10 analysts covering them.).

The goal of the SEC’s tick size pilot program is to encourage real liquidity providers to return to the small cap arena while discouraging the predatory, high frequency penny jumpers.  Opponents of the tick size program are quick to say that they think the program will just widen spreads and increase transaction costs.  But the new SEC data proves that spreads are already wide in the small cap arena.  

We believe the tick size pilot program, if designed correctly, will be successful.   However, we believe the pilot program was proposed with too wide of a market cap scope.  The current plan calls for stocks with less than $5 billion market cap to be part of the pilot program.  Based on the SEC data, we believe the tick size pilot plan should be scaled back to include stocks with market cap of $2 billion or less.