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SEC Approves Tick Pilot

Last week, the SEC approved a proposal with modifications for a two-year program to study the effect of a change in tick size that will begin May 6, 2016. The release noted that, while “these changes could . . . impose costs, including on investors resulting from larger spreads,” proceeding with the pilot is worthwhile because “altering tick sizes could result in significant market-wide benefits and improvements to liquidity and capital formation.” The SEC hopes that the larger tick size will incentivize market making in the pilot stocks, thus attracting more investors to investing in these companies.

Pilot securities will be selected based on a three-month measurement period and consist of those with a daily closing price of greater than $1.50 and a closing price of at least $2 on the last day of the period, a volume-weighted average price of greater than $2 per day, less than one million shares in average daily volume, and a market capitalization of less than $3 billion. The pilot would exclude ETFs and those securities that had an IPO within six months of the start of the pilot period.

The test would split eligible securities into one control group of approximately 1400 securities and three test groups, each consisting of 400 securities. Eligible securities will be stratified based on consolidated average daily volume, market capitalization, and price, and then randomly assigned within each of those classifications to a test group to ensure a representative sample. Each of the test groups would impose the $0.05 tick size requirement, but add a slight variation. In the first test group, trades could occur at any increment that is currently permitted today. Securities in the second group could only trade in $0.05 increments, with certain exceptions for midpoint trades and retail order price improvement (of at least $0.005), and negotiated trades.

The third group would impose the same quoting and trading increments as the second group, including the same exceptions. However, the group would also be subject to a “trade-at” requirement that provides, during regular hours, a venue with no displayed liquidity at the price of the current protected quotation that receives a marketable order would either need to meet one of the provided exceptions (price improvement or midpoint execution), execute the order at the protected quote if it is of block size (greater than 5000 shares or $100,000 in market value), or route the order to execute against displayed orders at the protected quote at other venues after which it could execute the remaining balance at the then-protected quote. If the venue is displaying liquidity at the protected quote when it receives the order, it may only execute up to the number of display shares and then must route the order to other venues with displayed liquidity at the protected quote. In short, the requirement means that displayed orders would be prioritized for execution.

The impetus for the program is the 2012 JOBS Act in which Congress directed the Commission to conduct a study on the effect of decimalization on the number of IPOs and the liquidity and trading of small cap stocks. The Commission’s report to Congress and a subsequent roundtable suggested a pilot program to assess the impact of increasing the tick size in small cap stocks. In June 2014, the SEC tasked the exchanges and FINRA with developing a plan to implement the pilot, which was subsequently released in August 2014 for public comment.

In response to the request for comment, the Commission received 77 letters, of which 33 expressed general support, 17 provided substantive comments yet did not express overall support or opposition, and 20 generally opposed the proposal. Those opposed generally expressed concern that the pilot would increase costs for investors and that it would complicate an already complex marketplace. When looking at the specific design of the pilot program, the SEC received the most negative commentary on the Trade-At Prohibition, with 27 commenters in opposition, largely due to added complexity.

In response to comments, the SEC made various changes to the program. For instance, the order lengthened the pilot from one year to two, lowered the market capitalization threshold from $5 billion to $3 billion, and altered certain data reporting requirements for market makers and trading venues. The SEC also made certain changes to the trade-at requirement, such as lowering the threshold for the definition of a “block trade,” altering routing requirements for marketable orders received, and utilizing the less restrictive “protected quote” as opposed to the NBBO.