SEC Roundtable On Decimalization Raises Many Questions, Few Answers

by Pepper Hamilton LLP
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The Securities and Exchange Commission (SEC) held a roundtable forum on February 5, 2013 to solicit financial industry views on “decimalization” in accordance with the directive under Section 106(b) of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act).1 The three panels comprising the roundtable studied the following topics:

  • evaluating concerns relating to tick size for small and middle-capitalization companies
  • evaluating concerns relating to tick size for the securities market generally
  • studying the effects of alternative tick sizes.

Participants in the roundtable ranged from staff members from the SEC’s Divisions of Market Regulation and Corporation Finance, executives from buy-side and sell-side financial firms, stock exchange executives, venture capitalists, members of the market research community and distinguished university faculty members. None of the participants in the roundtable represented small or mid-cap issuers.

Decimalization

“Decimalization” refers to the trading of stocks in one-penny increments, as opposed to fractions, which had been the case prior to April 9, 2001. Prior to 2001, stocks traded in fractional increments, which most commonly were expressed in 1/16ths2 – the equivalent of $0.0625 increments – or greater. For instance, a stock is no longer “up 1¾,” it is “up $1.75.” Decimalization was thought to bring about more precise trading and capture the true value of a stock, since the stock could tick up or down one cent instead of waiting until a market traffic changed the quote by $0.625. Also, with narrower spreads, a specialist on the New York Stock Exchange required less capital to bridge the gap between buyers and sellers.

High-Speed Trading

A strong perception resulting from the advent of computerized and programmed trading in the early 2000s, and so-called “high-speed” and “hide and slide” techniques, has been that smaller institutional and retail investors were at a comparative disadvantage to professional traders in obtaining the best possible price, and that quotes have become so jumpy as a result of computerized algorithmic trading, that an investor is not likely to be able to execute a trade at the quote displayed. Often, a stock can move significantly between quote and execution.

The “flash crash” on May 6, 2010 - when the Dow Jones Industrial Average suffered a 600-point loss in five minutes, followed by an equally dramatic recovery – solidified the view that high-speed computer trading had created a precarious house of cards where the small investor had an uneven playing field and, worse, where even the program traders themselves had lost control of their machines. On August 1, 2012, Knight Capital suffered a similar technical glitch in its algorithmic trading systems, causing more than 140 stocks to be mis-quoted, eventually costing the firm more than $440 million and forcing it to raise significant capital.

The JOBS Act

Section 106(b) of the JOBS Act directed the SEC to conduct a study examining decimalization, and its impact on initial public offerings. In addition, the SEC was empowered by the JOBS Act to raise the minimum incremental bid for emerging growth companies - essentially firms going public following the JOBS Act with less than $1 billion in total revenues who elect emerging growth company status3 – from $0.01 to up to $0.09. For example, if implemented by the SEC, an emerging growth company might trade at $20.00, then $20.09, then $20.18, then back to $20.09, etc., rather than in one-penny increments.

SEC Study on Decimalization

The SEC published its findings in a study released in July 2012.4 The study observed that smaller tick increments brought about by decimalization generally improved investor pricing by allowing for tighter execution. However, the heavy presence of high-speed trading has actually reduced transparency and predictability of execution price. Moreover, the narrower spreads between bid and ask have reduced market maker compensation since, using our above example, a customer bid and ask might be as tight as one penny, whereas before there was a minimum bid/ask spread increment of six-and-a-quarter cents. Tighter market maker compensation has resulted in less liquidity for small-cap stocks, since most broker-dealers will not find the reduced compensation enticing enough to invest in making a market in small-cap stocks which typically have lower volumes and therefore less trading flow. When a stock has fewer market makers, research coverage is similarly reduced. Notwithstanding this outcome, no empirical data was conclusive on the impact of decimalization on capital-raising.

The study’s ultimate conclusion was that rulemaking concerning changes to decimalization for emerging growth companies was premature, and that views of market participants should be solicited at a roundtable discussion.

The Roundtable

The roundtable raised a number of interesting points to consider, including most prominently:

  • Should increased tick sizes return for all stocks or just emerging growth companies?
  • Will increased tick sizes reduce market volatility and put the brakes on high-speed trading?
  • Will increased tick sizes incentivize more broker-dealers to make a market in small-cap stocks, including initiating research coverage?
  • Should the increased tick size be uniform? Should issuers have the option of electing their own tick size?
  • Do companies appreciate the difference between tick increments to the point of making an informed decision?
  • Will retail investors have greater visibility on ultimate execution pricing with greater tick sizes?
  • Will trading firms turn to internalization – trading among their own clients - at smaller tick sizes that blur market transparency?
  • Will increased tick sizes prevent the flash crash and other disruptive technical incidents?
  • If this leak is plugged, will ever-creative market participants think of another method to achieve an advantage, possibly risking market integrity?

A consensus arising out of the roundtable was that until a change is made, panelists were merely speculating about the impact. To that end, a recommendation was made that a pilot program be implemented to “test drive” a change in decimalization, and that the program should be long enough to observe real data and side effects/unintended consequences over various market cycles and platforms.

Pepper Points:

  • look for more studies to be done in this area as new faces join the SEC and SEC staff or are promoted to higher positions
  • Neither the investment banking community nor the highly-fragmented IPO issuer world have been clamoring for larger tick sizes, despite the potential benefits of higher trading compensation (for market makers), greater research coverage (for issuers) and greater pre-trade pricing transparency (for investors)
  • Like other portions of the JOBS Act, changes to decimalization may ultimately prove to be a solution looking for a problem
  • On the other hand, increasing decimal spreads may add an element of adult supervision to the equities market that will allow investors to wrestle back control from the machines.

Endnotes

1 The text of the JOBS Act can be found by following this link: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf.

2 Depending on the market and a stock’s trading price, fractional quotes would sometimes be as low at 1/32 increments.

3 Under the JOBS Act, an “emerging growth company” is: an issuer that had total annual gross revenues of less than $1 billion (as such amount is indexed for inflation every five years by the SEC to reflect the change in the Consumer Price Index (CPI)) during its most recently completed fiscal year. An issuer that is an emerging growth company as of the first day of that fiscal year shall continue to be deemed an emerging growth company until the earliest of: (a) the last day of the fiscal year of the issuer during which it had total annual gross revenues of $1 billion (as such amount is indexed for inflation every five years by the SEC to reflect the change in the CPI) or more; (b) the last day of the fiscal year of the issuer following the fifth anniversary of the date of the first sale of common equity securities of the issuer pursuant to an effective registration statement under this title; (c) the date on which such issuer has, during the previous three-year period, issued more than $1 billion in non-convertible debt; or (d) the date on which such issuer is deemed to be a “large accelerated filer,” as defined in Rule 12b–2 of the Securities Exchange Act of 1934, as amended, or any successor thereto.

4 See http://www.sec.gov/news/studies/2012/decimalization-072012.pdf for the complete July 2012 study on decimalization.

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