For several years, a few market veterans have carried on a wistful, even quixotic, campaign to recover a lower-tech, higher-touch version of stock trading, by reverting to swapping shares in five-cent increments instead of pennies.
Recently, the idea of at least experimenting with nickel-wide price gradations for some stocks has earned the support of more of the Wall Street establishment, ahead of a key vote on Friday by a committee that will make recommendations to the Securities and Exchange Commission on market-structure changes.
While the majority of the so-called Investor Advisory Committee is opposed to the change, a vocal minority backed by senior executives at some large firms continues to push for a pilot program in which some small-cap stocks would be priced in nickel increments.
Machine vs. man
The advent of decimalization of trading in 2001 and the increasingly high-speed, automated approach to trade execution has rendered the stock market largely an argument among machines over slices of pennies. With dozens of exchanges and other trading venues vying for order flow and opportunistic computer-propelled middlemen jockeying in microseconds for a fleeting advantage, the explicit costs of trading have plummeted.
But the secondary cost to “real money” institutional traders, such as mutual funds, from the lack of displayed buying and selling interest and illiquid behavior in many smaller stocks has remained frustratingly high. Big funds fear front-running by systems built to detect large orders and step ahead of them electronically for a penny or less.
The Wall Street Journal this week thoroughly detailed the way regulations intended to promote competition and lower trading spreads for retail investors have resulted in an unwieldy tangle of rules, order types and a whole industry focused on trading the electronic “noise.” Traditional market-makers, both on exchange floors and “upstairs -- which admittedly earned huge returns for many years through relatively riskless intermediation – largely went away.
Jeff Solomon is chief executive of Cowen Group’s (COWN) Cowen & Co., a long-lived institutional brokerage, and is co-chair of the Equity Capital Formation Task Force, which seeks to find ways to promote capital-raising by smaller companies. Pointing to a steep decline in the number of stocks listed in the U.S., the reduced output of investment research on small companies and a dearth of smaller initial stock offerings, Solomon argues that illiquid trading related to “penny jumping” keeps companies from accessing the market and leaves a big group of littler public companies effectively orphaned. The task force report is here.
For large institutions, it is often “too risky to put capital at risk in penny increments,” says Solomon, who spent 20 years in asset management and saw directly the way illiquid pockets of the market deter investors from participating, raising the cost of corporate capital.
He's trying to rally support for a pilot program to trade shares of companies with market capitalizations below $750 million in five-cent ranges. The pilot, which would cover just 2% of total U.S. stock-market value, is intended to “create incentives for fundamental buyers and sellers to interact. We think wider increments will cluster volume” on those nickel price points. This is analogous to agreeing with other people to meet – or set up a bus stop -- on a particular street corner rather than at some random point along an avenue.
Most of the industry either outright opposes the idea as a regression from ultra-fast and ultra-cheap trading, or believes that at least large firms that aggregate retail order flow and “internalize” the trades by matching them up themselves should continue to be able to cross trades in pennies or sub-penny ticks.
A more extreme and wishful stance is taken by James Maguire, a New York Stock Exchange specialist for more than six decades who oversaw trading in Berkshire Hathaway Inc. (BRK-A, BRK-B) and remains friendly with Warren Buffett. I dubbed him Mr. Nickel years ago in Barron’s for his passionate crusade to trade all stocks in five-cent ticks and last year took another look at his efforts.
Even in a comfortable retirement and having suffered a life-threatening illness two years ago, Maguire continues to pepper SEC Chairwoman Mary Jo White with letters pressing his case. On a recent frigid morning he ventured back to the NYSE, put on his old badge, No. 92, and reiterated that decimals have brought about the “unmitigated disaster” he predicted they’d be.
The old NYSE stock-trading operations are a trivially small piece of its new parent company, Intercontinental Exchange Group (ICE), which is a mostly electronic derivatives exchange operator. There's little hope of reverting to the days when humans handled a substantial portion of the trading flow.
Yet other institutional players clearly assert the need for a broad re-thinking of trading mechanics. Andy Brooks, head of U.S. equity trading at $650 billion asset manager T. Rowe Price Group (TROW), says he believes a test of nickel trading makes sense – and not just for small stocks. He points out that even some blue chips tend to trade sloppily and could benefit from inviting more activity on the bid and offer sides with slightly wider price spreads.
His job is to buy and sell large blocks of stock on behalf of exactly the sort of smaller investors and retirement-plan participants the order-handling regulations were meant to help. Yet, each day he has to navigate around storms of quicksilver orders from programs who find it inexpensive to get in the middle of trades. He thinks it’s worth trying to put some of the “grease” back in the machine to reduce such friction.