Could the fix for our convoluted, hyper-fast stock market be something as old-fashioned as nickels and dimes?
Payphone calls cost five cents until 1951. The first Superman comic book carried a 10-cent cover price in 1938. And the idea of trading stocks in wider “tick sizes,” such as five or 10 cents, has been in the Wall Street air almost since the moment the exchanges and the Securities and Exchange Commission implemented “decimalization” in 2001, mandating that most stocks be quoted in penny increments. This ended the days of fractional trading in sixteenths and eighths of a dollar.
Now one of the biggest investment houses, Citigroup Inc. (C), has filed a formal comment letter with the SEC suggesting a pilot program to test five- and 10-cent wide trading increments in some smaller, less-liquid and very high-priced stocks.
“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 relative success or failure,” wrote Daniel Keegan, head of equities in the Americas for Citigroup Global Markets. SEC Chairwoman Mary Jo White is soliciting industry input on a variety of equity market structure issues in hopes of improving reliability and liquidity.
While penny trading has driven down the spreads between where stocks are bid on by buyers and offered for sale – especially in the most heavily traded stocks – the practice is also blamed for inviting automated trading strategies that seek simply to scalp stocks ahead of other orders for fast profits that, in some cases, are mere fractions of a cent.
The front-running risk
As a result, market makers and large investors are frequently loath to express a public buying or selling interest in stocks of any real size, in part because it exposes them to relatively low-risk, legal front-running of their orders. The public bid and offer sizes and average size of a trade have collapsed since decimalization arrived, sapping the displayed liquidity in most stocks and stripping the profitability from the market-making business.
As traditional middlemen have fallen by the wayside, algorithm-propelled high-frequency traders have stepped in as the de facto market makers. In many large stocks this is just fine, making trade execution fast and seamless. But because the HFT players have no obligation to “take the other side” of public orders, liquidity can be fickle. And in smaller, thinly traded stocks, very little trading occurs.
One man has long been a resolute but lonely voice advocating a return to wider tick policies. James Maguire, who began as a specialist on the New York Stock Exchange floor in 1950 and long handled trading in shares of Warren Buffett’s Berkshire Hathaway Inc. (BRK-A, BRK-B), has been calling for a return to nickels for more than a decade.
Now comfortably retired with no financial motivation for advocating a give-back to the market-maker community, he’s still at it, calling what we now see from 9:30 a.m. to 4 p.m. Eastern time each weekday “a toxic market.” I dubbed him “Mr. Nickel” in 2005 in a profile in Barron’s, and he has continued to jawbone SEC officials to push his cause.
Maguire points out that the original SEC rule on decimalization allows for ticks “no wider than five cents,” so the regulations already accommodate the possibility. He has railed against the domination of HFT firms and seeks to restore a modicum of profit to the intermediaries who help smooth out trading and provide liquidity in jumpy markets.
Smoothing out the chaos
Art Cashin, the longtime head of NYSE floor operations at UBS AG (UBS), once described wider ticks as akin to bus stops in a city, gathering points where people know they’ll be able to get where they’re headed, as opposed to a more chaotic place where every passenger can hail a bus at any moment.
The whole debate about tick sizes has an element of returning the toothpaste back into the tube, of course. It’s undeniable that, for most small investors who care to invest on their own, trading has gotten only cheaper and faster. Bank of America Corp.’s (BAC) Merrill Edge brokerage division, for instance, is now promoting $6.95 equity and exchange-traded-fund trades, with no minimum account balance, undercutting by a dollar or so prevailing online commissions. For small orders, executions are virtually instant these days, whereas they used to be cumbersome, and a generation ago “discount” commissions were near $30.
Yet despite this, large funds have been consistently frustrated by the lack of liquidity for larger orders, the need to have algorithms slice them up in bits to get done over the course of the day and the periodic system failures such as the 2010 “flash crash” and the Nasdaq outage this past summer.
There is broad acknowledgement that the market is, if not broken, then punitively complex and rickety, with dozens of order types, some 40 exchanges and other trading venues and hundreds of forgotten stocks that “trade by appointment.” Despite stock indexes trading near new highs, share volume has not increased commensurately the way it tended to do in past bull markets.
Some have argued that the lack of smallish initial public offerings and the dearth of sell-side research coverage in littler stocks might be remedied in part by restoring some profits to the market-making part of the equity-trading business.
While critics claim, with some legitimacy, that this is something like voting for a tax increase, Citigroup, its large fund-running clients and others seem to think it’s worth the time and effort to run a nickel-and-dime experiment to see if some of the unintended consequences of penny trading can be undone.