Global LEI Rankings: Third Quarter 2014

The tick-size pilot is an excellent experiment that is destined for the market structure scrap heap in the sky. While in favor of a test, I do not foresee positive results, such as greater research coverage, more small-/mid-cap IPOs, a wider diversity of market makers, reduced impact of high frequency traders, lower transaction costs, or better quality equity markets. The only result we can foresee from the pilot will be greater displayed liquidity; however, that liquidity may be just as transient or difficult to grab as it is today.

Why do I believe this program won’t go anywhere?

The pilot program
• A control segment in which all rules will remain constant;
• Pilot 1, a target group of securities that will quote at nickels but can execute at any increment;
• Pilot 2, a target group of securities that will quote and trade only at nickels, with the ability to improve price by half-tick increments (Minimum Price Variation – $0.025) through internalization, dark pools and on displayed markets (exchanges and ECNs);
• Pilot 3, a target group of securities that will quote and trade only at nickels, with the added kicker of a Trade-At provision that will mandate that order flow can only trade off-exchange (internalized or in dark pools) if the trade improves the quoted price by at least 1MPV or, in a 1MPV market, at the mid-point. Brokers and dark pools will no longer be able to match the bid or offer away from a quote displayed on an exchange or ECN.
• There are also limited exceptions for bona fide retail trades and other limited negotiated trades.

The first challenge in measuring a Tick-Size Pilot that fulfills the intent of the JOBS Act to stimulate IPOs and create jobs is that the test is just too short. If the result is to stimulate the market for small- and mid-cap IPOs by creating incentives for boutique investment banks to build out research, market making, and banking businesses, a yearlong pilot does not provide enough time to hire qualified people, develop the infrastructure, and create a pipeline to demonstrate measurable results.

If new underwriting is not a success factor, what would other success factors be?

Given a yearlong test, I believe that we could see demonstrable results for these six metrics:
• Increased market efficiency (reduced transaction costs);
• Greater liquidity;
• Larger transaction size;
• Increased certainty of execution;
• Less off-exchange activity and greater price discovery; and
• An increase in the body of market-making firms outside traditional high-frequency market-making firms.

Pilot 1 will most likely cause markets to go dark. If firms can execute at any increment, why trade only at the nickel?

With Pilots 2 and 3, we will see decreased liquidity. As we widen spreads, there will be fewer trading opportunities and the cost to trade will increase. Also, we will not see new market makers come into the market, and speed will only become more important as the benefit to being on the top of the book will increase. In Pilot 3, we will see exchange market shares grow but, overall, volume will most certainly decline as the incentive to trade in the dark, the penalty of reversion and adverse selection, and the cost of information leakage only increase.

In addition, Trade-At will significantly increase market complexity and reduce execution-certainty, as exchanges will not be able to tap into hidden reserves before routing to away markets. Further, the one-year duration gives firms pause to significantly invest, as why invest if the future is uncertain? This will give rise to a calamity and increasing systemic risk.

At the end of the day, the only way we can measure success is by market efficiency and, more specifically, the market efficiency at the exchange level, not the client level, as institutional clients are very unlikely to share this information voluntarily. By this success rubric, all of these pilots will fail. By almost any measure (except for greater displayed liquidity, larger transaction size and growth in on-exchange market share in Pilot 3), the current market structure (i.e., the control group) will have displayed not only better, but demonstrably better market quality statistics than any of the pilots.

If we were to craft a tick-size pilot, we would only move forward with Pilots 1 and 2. The Trade-At provision creates significant market complexity and programing intricacies for slim, if any, benefit.
While we are not confident that we will see positive results for any of these pilots, we do believe we should move forward with a pilot. There are enough market structure naysayers and questions about the impact on spreads to the wider economy that it is important for these tests to be run. In addition it is categorically unacceptable for the number of publicly traded companies to decline by almost 50% over a two-decade span; and if a few short-term pilots can give us insight one way or another into these disturbing trends, then we should absolutely get out our yardsticks and try.