November 20, 2013
On November 11, 2013, the Equity Capital Formation Task Force delivered a report to the U.S. Treasury titled From the On-Ramp to the Freeway: Refueling Job Creation and Growth by Reconnecting Investors with Small-Cap Companies . The report focuses on how to better get startups and small cap companies the public capital that they need to grow. We would to call attention specifically to one of the two recommendations that the task force made which has to do with increasing the tick size for small cap stocks:
Encourage increased liquidity in small-cap stocks by fostering a simpler, more orderly market structure for small-cap companies and investors.
2.1. The national exchanges should conduct a pilot trading program, overseen by the SEC, in which select small-cap companies trade under new Small-Cap Trading Rules (STaR). Under STaR:
2.1.1 Participating companies will have market capitalizations below $750 million.
2.1.2 Participating companies should be quoted in minimum price increments of $0.05 and trade only at the bid, the offer or the mid-point between the two.
In a recent note to our clients, we highlighted an SEC comment letter from Citigroup that sought to give internalizers the ability to offer minimal price improvement from the NBBO. We disagreed with Citigroups suggestion and stated, Allowing internalizers to jump ahead of displayed liquidity for de minimis price improvement would continue to discourage displayed liquidity and harm the price discovery process. Our opinion aligns exactly with that of the Equity Capital Formation Task Force – trades in the tick size pilot program should only be allowed at the bid, offer or the mid-point between the two for stocks that are in the pilot program.
We expected that certain firms that rely on the economics gained from the sub-penny price improvement model would take issue with our stance. We take issue with a recent SEC comment letter from TD Ameritrade which seems to suggest allowing sub-penny trades that offer de minimis price improvement in the small-cap tick size pilot program. They claim to want to keep the pilot program simple so that the results of the program are not tainted. They stated in a SEC comment letter Simplicity in an otherwise confusing environment should not be overlooked. But is TD Ameritrade really giving policy makers all the facts about the economics of their order routing?
A quick look at their 3rd quarter 606 report shows that TD Ameritrade is paid less than $0.002 per share for market orders that are directed to market makers. In the 3rd quarter, TD Ameritrade sent 2/3 of their equity market orders to Citadel Execution Service and 1/3 of their market orders to Citigroup. If these market orders were sent to an exchange, TD Ameritrade would have had to pay a take fee (their take fee with Direct Edge was $0.0015 per share). Here is the problem for the online brokerage community – if internalizing market makers are not allowed to step ahead of the displayed quote with sub-penny price improvement, then the online brokers would have to send these market orders to the lit exchanges and incur a take fee. This would mean rather than getting a rebate of $0.002 per share, they would have to pay at least $0.0015 per share.
Most likely these online brokers would not be able to charge only $7.95 for these orders without the current rebate subsidies that they have been receiving. No doubt this was probably their argument when they met with senior SEC staff on November 13th. But we look at it a bit differently. If the online brokers were not receiving rebates and selling their order flow, then the price discovery process would be cleaner and displayed limit orders would not get stepped in front of by internalizing market makers. This would encourage more displayed and deeper pools of liquidity.
We agree with the Equity Capital Formation Task Force that policy-makers now have a critical opportunity to seize the momentum generated by the JOBS Acts success and apply its principles more broadly to benefit even more promising small companies – now and in the future. We just hope that the conflicted interests of certain brokers do not get in the way of such a promising program.