December 5, 2019
How to Help Thinly Traded Securities
Comments to SEC Release No. 34-87327
File No: S7-18-19
There have always been liquidity issues with small public issuers. Whether they were exchange listed or trading in the OTC market, small companies have always struggled to raise capital, go public in the US, find shareholders, research coverage, etc. This is a natural problem and makes perfect sense if you think about it. This problem is not new. Even when financial markets acted as they were intended, that is, a way for entrepreneurs to meet investors, it was difficult for smaller companies to take advantage of them. Most investors prefer larger, more established, later stage, less risky, investments. Even so, ours was a capital forming system, where Apple Inc. could go from a penny stock to the highest valued company in the world.
However, the problem is worse than it has ever been. The reason is very simple. Small companies, before and after their IPO, were supported almost exclusively by small broker/dealers and Investment Banks. Small investment banks provided an ecosystem that would nurture these companies from private placement, to IPO, to trading in the aftermarket (market making), to research, and their retail brokers recommending their shares to their clients in the aftermarket. In general, none of this exists today. There are some firms that do bits and parts of each but not to the degree that is needed.
The result is, the ecosystem that nurtured these companies has been destroyed by rule changes, technology, and of course overregulation. Each step in this process has been systematically gone after, and destroyed. We have had fundamental changes made to the way securities are traded, namely the removal of the market making role and the spreads that supported them, without any thought as to the effect it would have to our country, our economy and most importantly the capital formation process.
We all know the statistics in regards to the number of Broker dealers that exist today compared to 20 years ago. However, it is even worse than the numbers suggest. The number of broker/dealers that are still involved in the capital formation process for small public companies, and still participate in this ecosystem, are now a very small percentage of total firms today.
Since the Commission's focus in this statement is on post IPO issues (i.e., trading liquidity in the aftermarket) I will focus my comments on how a hand full of rule changes over the last 20 years have led us to where we are today. Most of these changes were implemented in the guise of the public good. Namely, lowering transaction costs for retail investors. Some changes were simply brought about by advances in technology. However, just because we can do something new, doesnt always mean we should. And as always, the individuals that allow these changes to our capital markets and in most cases, push for these changes, have no idea how they will affect the capital markets down the road. Then, when they do realize we have a problem, they want to make new rules years later to try to fix what they interfered with.
Going back to the way things were would mean they made a mistake. I understand this, but the issue is too important to worry about peoples feelings. If we are serious about bringing back support for these small issuers (liquidity) we must first bring back the ecosystem that had supported them for over 200 years. This means letting (encouraging even) small broker/dealers to perform the function they always have on these companies before and after they are public.
The integral role of Market Making and why it needs to be brought back Market Making was a historic source of income for small broker dealers. After an IPO the firms that participated would make a market in these shares. Every day there were numerous firms willing to commit their capital to buy and sell these shares (provide liquidity). They performed the same function as the Specialist on other exchanges.
Market Making is all but non-existent in small public companies today. Why? Two reasons, overwhelmingly over regulation, and rule changes, have removed the incentive for broker/dealers to make markets.
ECNs
The first event that helped destroy market making was the development of ECNs (electronic trading) in the late 1990s these ECNs were allowed to join the NASDAQ consolidated quotation system and compete with the quotes of broker/dealers. They did not need to be licensed as a broker dealer, or commit capital to make markets like broker dealers had to. This was the first step in the destruction of market making. This electronic trading also led to the death of the Specialist on the NYSE floor. This activity was encouraged because it narrowed spreads and cut down transaction costs for investors.
SPREADS (decimalization)
The second event that lead directly to the death of market making was decimalization. In general, this has led to much smaller spreads in all securities than prior to decimalization. Its no secret Market Makers make profits with the spread. Even if most of the time its not the whole spread. The spread gives trading opportunities. It is the only incentive to make markets.
Spreads have a purpose. They didnt just happen. Our capital trading markets were developed with a Bid/Ask system for a reason. It could have just been one price, but its not. There is a reason for a spread. When we removed them, by trading stocks in pennies, instead of designated amounts according to share prices, (such as fractions) it really effected small public companies. It didnt affect Microsoft. Microsoft already has a huge public following. Microsoft doesnt need a spread, to encourage market makers to trade the stock, small companies do.
We want investors and not traders in these securities.
The spread is also very important for another reason. It ensures that we have investors in these small companies, not day traders. These companies need long term investors. In the past, when an investor bought a stock, they paid a spread, and a commission, maybe a mark-up. This means that the stock actually had to go up before the investor could sell and make any money. In some cases it was a significant percentage. With the removal of spreads, the cost of a transaction is minimal (and now free). There is now little incentive to be a long-term investor. So now we have a market full of day traders who think our capital markets are a pinball machine, instead of investing.
I understand the SEC has conducted a test on certain securities to bring back spreads. I commend them in this effort. However, there is a problem with this. If there are no longer market makers around to take advantage of these spreads how do you expect the test to work?
Broker/dealers must be encouraged, and incentivized, to perform these functions, not constantly scrutinized by the regulatory agencies that regulate them. If this is ever going to work the regulatory agencies must realize, and value, the function that these services perform for our capital markets.
Bring Back Spreads and Market Making
We had a system that was the envy of the world for almost 200 years until we destroyed it. Spreads must be brought back for all securities, not just small companies. If large cap securities have little, or virtually no spread, and small caps have significant spreads, investor capital will shy away from buying small companies because of the added expenses. All securities must have spreads. Spreads will encourage firms to make markets. Small issuers that are trading will be supported by these market makers and liquidity will increase.
All securities should be traded in designated amounts according to share price. Nickels, Dimes and quarters, not pennies. FINRA must encourage firms to make markets again. There must not be extra scrutiny on firms that choose to do so.
The regulation that destroyed the market making was based on the assumption that all investors are good and must be protected, but all market makers are evil and serve no purpose but to make money.
However, the spread for the Market Makers was the incentive to commit capital to buy and sell a security even when they are thinly traded. This function and capital to support and smooth out market movement is currently missing.
A market maker would get to intimately know the company and the stock they were trading and act as a stabilizing function between buyers and sellers. Once you remove the system, you have the securities that have volatile trading patterns that lead to investors not wanting to buy or invest in these securities. This creates the thinly trading circumstances we currently find ourselves in.
There is no need to develop a new market/exchange for these securities. I also understand the SEC has considered starting a new market for these small public companies. This is not necessary. We already have OTC Markets and NASDAQ small cap markets (NYSE AMEX also). SEC simply needs to bring back spreads and market makers and fix some other important issues on these exchanges.
OTC Markets
It is extremely difficult getting securities traded on these markets. To get traded on the OTC Markets a Broker/Dealers must file a form 15c211 with FINRA. This is a long and arduous process where a broker/dealer is basically vertifiying a companys information.
Broker/dealers cannot get paid for these services and the risk they are taking to file these applications and their due diligence. Even if the company is eventually approved to trade, FINRA has made it virtually impossible for shareholders to deposit shares of these companies at Broker/dealers. There are now only four clearing firms that accept deposits in these shares. If investors cant deposit their shares to trade, how can you expect a market to develop for these issuers? Most importantly, how do you expect these companies to be able to raise capital?
SEC and FINRA must encourage small broker dealers to work with these issuers, get paid to file form 211 and conducting due-diligence, and we must be allowed to accept deposits in OTC Markets Securities.
Most importantly, there must be scrutiny by FINRA if we choose to do this business, but it also must be encouraged. A broker/dealer that chooses to commit to these illiquid securities cant be treated like they are committing a crime.
Changes in regulations has had a major effect on supply and demand of thinly traded securities.
All markets trade based on the law of supply and demand however, the current and past regulatory actions has significantly affected both areas.
The recent actions restricting the ability of thinly traded OTC securities to deposit and clear their securities has had a major effect on the supplies of the securities.
On the demand side the regulatory requirements of the low price security rule, which effects OTCBB stock under $5.00, restricts brokers from soliciting buys for these types of securities. The majority of broker/dealers will not allow their brokers to solicit these types of securities which significantly effects demand.
If both supply and demand is restricted it is obvious that liquidity is becoming a thing of the past for OTC securities that are thinly traded.
NASDAQ Small Cap Markets (Capital Market)
Recently, NASDAQ has changed their listing requirements. Now shares held by shareholders who sign a lockup agreement at the time of an IPO no longer count in the market value of publicly held shares. This effectively means that to do an IPO onto NASDAQ companies must raise $15mm. Virtually eliminating small IPOs for companies that are not yet profitable or even pre-revenue such as biotechnology companies developing new drugs that raise less than $15mm.
This move by NASDAQ was done to try and increase liquidity for these smaller issuers. More shares in the public float equals more liquidity. Makes sense, however, like all regulations and new rules there are unintended (or maybe intended) consequences.
The result is that in the USA TODAY WE DO NOT HAVE A NATIONAL EXCHANGE FOR THESE COMPANIES.
The reason there is no liquidity for these small companies is because the ecosystem that supported these companies is gone. There are no marker makers trading these stocks. There are no broker/dealers recommending these shares to their clients. The net result are these shares are very thinly traded and their price swings can be extreme because there is no market maker stepping in to provide liquidity when needed. This was the number one function for market makers and specialist.
Again, shares of Microsoft dont need market makers. There are plenty of buyers and sellers EVERY DAY. However, it is extremely important for small issuers.
Instead of developing a new exchange for these companies the SEC should use OTC Markets and NASDAQ small cap NYSE (AMEX) as a venue for these companies. These markets should trade with spreads (increments according to price, .05c, .10c, .25c) and market makers. I believe this initial step will have a huge effect in supporting these companies.
CONCLUSION
We dont need another experiment with our capital markets. We had a system that worked for almost 200 years, encouraging capital formation and creating the largest economy the world has ever seen. This system no longer works for small companies in the USA that create most of the new jobs for our economy.
It is broken because of specific changes to our market structure and over regulation of small broker/dealers that have supported these companies for 200 years.
We dont need new rules, we need to get back to our roots when our capital markets were for capital formation as intended, not day trading algorithms.
A huge step in this direction would be bringing back spreads, market making and relieving oppressive overregulation on small broker/dealers that perform these functions.
Keith Testaverde, Sr. Vice President
Network 1 Financial Securities, Inc., Member FINRA/SIPC