Sub-Penny Ticks Are a Bad Idea
We continue to think that SEC’s sub-penny tick size proposal is a bad idea because it will likely result in visible quote fragmentation and volatility, sub-penny quote-jumping, flickering quotes and increased message traffic. While some stocks may warrant consideration of a smaller tick size, we think any suggestion of reducing the tick size to $0.001 or $0.002 is a bad idea.
Why did the SEC propose $0.001 and $0.002 tick sizes? According to the SEC’s proposal, here are a couple of reasons why they proposed sub-penny ticks:
“One reason why the Commission chose the particular tick size cutoffs in this proposal was to have sufficient ticks intra-spread to preserve meaningful price improvement.”
“The Commission is proposing to apply the amended rule 612 minimum pricing increments to the quoting and trading of NMS stocks in order to promote fair competition and equal regulation between trading in the OTC market and trading on exchanges and ATSs, particularly as it relates to retail order flow.”
We think the SEC proposed sub-penny ticks to work in conjunction with its Retail Order Competition proposal in order to create a more competitive system for retail orders. The current retail order routing system, which is heavily reliant on PFOF, would no longer be economically feasible if tick and trade increments were harmonized at $0.001 and $0.002. While we would like to see more competition for retail order flow and the end of PFOF, we’re concerned that the SEC sub-penny tick proposal will create a number of new problems.
We have a couple of questions about the SEC’s sub-penny tick proposal:
1-What defines a tick constrained stock?
Based on all the research reports and comments that we have seen so far, most industry participants seem to favor ½ penny ticks on “tick constrained stocks”. But what defines a tick constrained stock? The SEC defines tick constrained with a Time-Weighted Average Quoted Spread measure. For example, they are suggesting $0.002 ticks for stocks that have a spread greater than $0.008 but less than or equal to $0.016. In their proposal, the SEC estimates that 1,707 stocks would qualify for either a $0.001 or $0.002 tick size.
But is a one-dimensional spread analysis the best way to define tick constrained?
We think the Cboe came up with a better method to define tick-constrained. Cboe contends that there needs to be “objective and selective criteria” used to determine which stocks are truly tick constrained. They propose that the criteria should be: tight average inside quoted spread, high quote-size-to-trade-size ratio (Quote-Trade Ratio) and high average daily notional turnover (Notional Turnover Ratio). When using this multi-dimensional approach, the Cboe whittles down the over 10,000 securities universe to only 67 securities that would qualify for a ½ penny tick.
2-What about a wider tick proposal?
A recent Stanford Business School paper titled “Tick Size Tolls: Can a Trading Slowdown Improve Earnings News Discovery?” looked at the data from the US Tick Size Pilot Program and concluded that the higher tick size led to a substantial drop in automated trading. The study noted that during the tick pilot, there was evidence that HFTs were not as active since their risk/reward due to higher ticks drove them away from the small cap segment of the market. In other words, wider ticks in less active stocks reduced the amount of HFT noise. We agree and think, in very difficult to trade small/mid-caps stock which have wide spreads, a wider tick may help promote more liquidity.
After Reg NMS was implemented in 2007, a host of new market structure problems were created and the era of high frequency trading took off. Major market structure changes, as well intentioned as they may be, often create unintended consequences or “unknown unknowns”. We fear that sub-penny quotes, especially $0.001 and $0.002, will create a whole new set of problems and a whole new set of opportunities for HFTs to take advantage of institutional and retail investors.
Our suggestion for the SEC would be to eliminate $0.001 and $0.002 ticks from the proposal and to adopt something similar to the Cboe methodology to determine if a stock is tick constrained and eligible for a $0.005 tick. We also think the SEC should consider including a higher tick size for wider spread small/mid-cap stocks.