July 2014
Market Microstructure
Who Gets the Short
End of the ‘Tick?
by Phil Mackintosh
CONTENTS
Origins of the pilot
3
The Crib Sheet
Greater impact is looming…
5
On June 24, the SEC released its directive for a new tick-size pilot
…But not necessarily on the stocks
you’d expect
6
Good news: Wider spreads should
increase depth
7
Bad news: Market impact may also increase
9
for the market.
Three separate pilots affecting 900 stocks for 12 months.
The initial impetus for wider tick sizes was to boost initial public
offerings and research in small-cap stocks. The $5 billion market
cap cutoff, however, means this pilot is including a number of
companies in the S&P 500. The inclusion of a one million average
daily volume cap and a trade-at requirement makes this pilot look
more like a review of liquidity and transparency, rather than a
stimulus for small-cap trading.
The SEC set the general parameters for the program, requesting
three pilot groups, each with 300 stocks and its own set of rules:
1. Quoted (displayed) at 5 cents (Can trade anywhere within
the NBBO)
2. Quoted and traded at 5 cents (Dark allowed at midpoint
and touch only)
3. Quoted and traded at 5 cents (Dark restricted to midpoint
unless removing lit NBBO)
The exchanges and FINRA are responsible for setting up the
pilot and quantifying the results for the SEC.
KCG | MARKET MICROSTRUCTURE 1
Who Gets the Short End of the ‘Tick?
We hope it makes illiquid stocks easier to trade
In theory, wider tick sizes should make the top of book deeper and less
volatile, making it safer to make markets and easier to trade size.
Exhibit 1: Full implementation of the rules
would see 66% of stocks quoted in 5-cent
increments (green).
Captured by Pilot Rules
By design, the wider ticks are expected to increase market making
1000
Yes
profits. The intention is to encourage more research and facilitation
No
of small-cap trades.
But complexity will increase
This tick-size proposal has the potential to be quite disruptive. We
estimate that two-thirds of the stocks institutions trade regularly will
pass the tests for a 5-cent trading increment (Exhibit 1). Ironically,
over 60% of these will not see their spreads widen, as their spreads
are already more than 5-cents wide.
But the additional requirements will increase the complexity of order
routing and limit trading (especially during the three-tier pilot).This
Number of Stocks
800
600
400
200
appears to be contrary to the overarching desire to make the market
Transaction costs are almost certain to go up for institutional
investors, as they are typically liquidity takers who cross the spread.
NanoCap
MicroCap
SmallCap
MidCap
LargeCap
And it’s likely that trade costs will go up
0
MegaCap
less complex.
Source: KCG Data
Transferring volume into dark pools would mitigate some of the wider
spread costs—this naturally occurs in stocks with wider spreads
now. The rules set out in Pilots 2 and 3, however, specifically counter
this, and thus will likely increase the effects of lit signaling, as well as
exchange payments.
KCG | MARKET MICROSTRUCTURE 2
Who Gets the Short End of the ‘Tick?
Back in April 2012, the JOBS Act was passed to include a directive
that the SEC examines how decimalization impacted small and
mid-cap companies. Specifically, the legislation focused on boosting
IPOs and support for small-cap risk trading and research.
The SEC staff report in July 2012 was mostly a review of academic
literature. It noted benefits of lower spreads and lower trading costs.
However, the report doubted that lower spreads have impacted capital
formation and questioned the link between spreads and incentivizing
block risk trading.
A simpler way to incentivize block risk trading in
small-cap stocks would be to increase the commissions
paid on those trades.
Consequently, the report concluded that the SEC should not proceed
with the specific rulemaking to increase tick sizes.
Despite this report, in February 2014 the House passed the
Duffy-Carney bill to force the SEC to create a pilot program.
Is small-cap liquidity really a problem?
It’s all relative.
Small-cap stocks are, by definition, well
smaller. So it’s no surprise that they trade less
value than large-cap stocks.
However, we can adjust for their smaller size
by looking at their annual turnover. This
shows that smaller stocks are materially less
liquid, and that this is especially true for
stocks outside major benchmarks. Despite
this, on average, most trade more than half
their market cap each year.
exhibit 2: Annual turnover for different
sized stocks
4
Annual Turnover
Origins of the pilot
3
2
for the market.
This pilot has a significantly different objective than the proposals from
the JOBS Act or the Duffy-Carney bill. It appears that the SEC has
recognized that widening spreads will not lead to the intended outcome
of the Duffy-Carney bill—job creation and capital formation. The focus
seems to have shifted to enhancing market quality, specifically looking at:
NanoCap
On June 24, the SEC released its directive for a new tick-size pilot
MicroCap
0
SmallCap
Pilot focuses on institutions, transparency and liquidity
MidCap
1
LargeCap
reports, it encouraged the SEC to revisit a pilot tick-size program.
MegaCap
Although this had not passed the Senate, according to recent
CAP SIZE GUIDE
Size
Market Cap Range
Mega
Over $50bn
Large
$2.5bn - $50bn
Mid
$750m - $2.5bn
Small
$300m - $750m
Micro
$100m - $300m
Nano
Below $100m
• Institutional investors: This is possibly in reaction to comments
that the winners from decimalization have been retail investors.
Source: KCG Data
Liquidity = annualized turnover for each company
• Transparency: Two of the three pilots will restrict dark pool trading
to preference lit venues without any changes to mandated exchange
pricing, as we discuss below.
KCG | MARKET MICROSTRUCTURE 3
Who Gets the Short End of the ‘Tick?
• Liquidity: Market cap cutoffs are materially expanded and, at
$5 billion, include companies in the S&P 500. The focus has moved
to address companies that trade less than one million shares a day.
• Preserving retail investor benefits: By providing for a retail
exemption, the SEC seems to be attempting to meet the demands
from Congress for implementing the pilot, but also ensuring that
retail investors don’t subsidize other market participants by paying
higher prices than they should.
Key pilot features—and why they may not all align with SEC goals
There are three pilots, each with different rules about what price
increments stocks can be quoted in and where trades can print
(see Table 1). Although the tick-size rules potentially affect thousands
of stocks, the pilot will only affect trading in 900 stocks.
• The 5-cent spread is designed to increase liquidity at the new, wider
NBBO while also making it easier to make markets in the affected
stocks. However, the addition of new trading increments and
trade-at rules in Pilots 2 and 3 add complexity to the program.
• By mandating, in Pilot 3, that broker dealers first take out the NBBO
before crossing internally, the SEC is directing significant flow to
exchanges. This seems an unusual step, given the overlapping
concerns over the impact of access fees on routing, as it will force
broker dealers to pay access fees to exchanges.
• Increasing transparency also appears to be at odds with the desire
to improve institutional investor trading. Under the rules, institutions
Table 1: How the pilots will work
Lit Market Increments
Trading in Dark/Grey Markets
Beneficiaries
Pilot 1
Pilot 2
Pilot 3
5-cent ticks
5-cent ticks
5-cent ticks
Anywhere in the NBBO
Midpoint and touch only a
Midpoint only a, b
Dark pools
Block traders
Exchanges
a
There is a retail exemption, provided price improvement is at least a half-cent.
Dark pools can trade at the touch in Pilot 3, provided they first sweep lit books.
Blocks are allowed to cross internally at the touch.
b
KCG | MARKET MICROSTRUCTURE 4
Who Gets the Short End of the ‘Tick?
will signal their trades to others more quickly and will be forced to
interact with market makers even though their broker already has
both sides of a trade.
Pilot 3 could lead to faulty conclusions
exhibit 3: A majority of stocks will be
impacted by the tick-size rules proposed,
although value traded is less affected.
Stocks captured by pilot rules
Tick Size Impacted
Will quote 5 cents
Will trade 5 cents
Testing the trade-at requirement without also coupling the test with
potential changes to maker-taker, locked markets or order types, for
No
1000
example, will make it difficult to draw actionable conclusions, since
these issues are all inter-linked.
400
200
Don’t expect an early arrival of results
It will be quite some time before we see the true effects and results of
100B
upon approval, it will run for a full year.
Greater impact is looming…
volume curves.
Stocks that are captured by the tick-size rules then need to pass all
these tests:
• NMS common stocks: Around half of all stocks in our universe
• Market cap up to $5 billion: Over 80% of all stocks in our universe
• Share price at least $2: Over 93% of all stocks in our universe
• ADV up to one million shares: Over 78% of stocks in our universe
40B
20B
0B
NanoCap
We start with a universe of just over 7,000 securities with available
60B
MegaCap
the proposal on stocks that are most commonly traded by institutions.
80B
Trading Value
In the pages that follow we study the impact of full implementation of
NanoCap
Value traded captured by pilot rules
MicroCap
All told, the pilot seems unlikely to start before 2015. Then, of course,
SmallCap
followed by an SEC evaluation of all comments.
MicroCap
MegaCap
how they’ll implement the pilot. Next up will be a public comment period
SmallCap
0
the tick-size pilot. The SEC is giving exchanges 60 days to agree on
MidCap
be considered for reform.
MidCap
unrelated areas of market structure—prompting that they, too, should
600
LargeCap
risk that results might mistakenly be used to draw conclusions on
LargeCap
to isolate the impact of wider spreads on liquidity. There is also greater
Number of Stocks
The inclusion of trade-at rules in the tick-size pilot will make it difficult
800
Source: KCG Data
KCG | MARKET MICROSTRUCTURE 5
Who Gets the Short End of the ‘Tick?
Big impact on all traders
Stocks with spreads wider than 5 cents
will still be impacted, as their quote
increment will be a multiple of 5 cents
(see the green areas in Exhibits 3 and 4).
We estimate over 2,700 stocks (two-thirds) pass all these tests.
Adding very illiquid stocks would increase this percentage. Amazingly,
over 60% of these stocks already trade with spreads wider than 5
cents (Exhibit 3). However the impact on value traded, which sums less
This may mean they will quote with
10-, 15- or even 25-cent spreads.
than $8 billion a day, is negligible.
…But not necessarily on the stocks you’d expect
Looking at the impact on a stock-by-stock basis, it’s interesting how
wide the spreads already are on many small-cap stocks. It’s also
surprising how broadly the proposed tick-size rules will be felt.
All of the stocks colored green and light blue in Exhibits 3 and 4 will
be impacted by the tick-size rule. In Exhibit 4:
• Light blue circles represent stocks that are likely to see their spread
increase up to 500%, as they currently trade with spreads under 5 cents.
• Green circles represent stocks that already trade at spreads wider
than 5 cents. However, because they don’t pass the liquidity test,
these stocks are also captured by the pilot rules, and will quote in
5-cent increments.
exhibit 4: Stocks that will see their spreads widened are shown in range.
(Circle size shows quote depth.)
CSPI SBSA
0.2
BVA
MXC
IPDN
TIK
CRV
DGLY FFNM
TRT
Spread ($)
0.1
0.05
EDUC AHPI
PBIB
RCON
ELSE
COBR
USU
GPRC
CRVP
GVP
AEY
$10M
IDI
TRK
IRG
JBT
HPJ
INTT
CIMT
CLUB
GILT
IMN
TINY
YOD
BIOD
CAMT
APRI
NX
AFG
IMI
$100M
PLX
IFT
HBIO
ENZ
UIS
III IG
AZC
RP
DO
TWI
LTS
AEL
AF
PF
TDS
ATU
AAN
HE
$1,000M
ST
EV
P
CCK
OI
Will quote 5 cents
AMZN
No
PPG
PRGO
AR
RL
CHTR
CP
VRX
CELG
MCK
CMI
LMT
GMCR
BEAV MTB
VMW
PH
NOC
APH HUM
AGN
APD
CBI
PX
AMP
FDX
CPG
ECL
KORS
CHKP
SRE
HSY
JAH
FL
Will trade 5 cents
ALXN
UNP
H
Q GIL
KN
CPIX
PRXI
CRDS
CBMX
CAS
FLT
BCR
IT
HI I
CUI
FCSC
ARG
SHW
HSIC
HAR
TSLA
CLR
ICE PXD ACT
PII
XEC CXO
TW
ANSS
R
B
TBI
ILMN
ADS WYNN
LNKD
BAP
TDG
AAP
CVD
CR
HNI
GNE
JVA
AMCF
DARA
DCTH
API
TPI
KIPS
HAST
BODY COOL
TG
MFI
IEC
CEMI
GTIM
KEX
SPW
BLFS
ANCI
CPA
BOKF
IOC ZU
IRIX
CF
EQIX
Z
THS
DW
ALTV
BVSN
AXR
RTGN
FRD
HIHO EFUT
BASI
PZZI
VIRC
MAGS
WGA
INS
ARIS
CAW
FCVA
IGC
0.01
DRQ
HITT
LL
FFG
AYI
AEHR
FFHL
0.02
AXE
CKH
GNCA
FCZA
NETE
DVCR
ERS
EVK
HUB.B
ATK
ROG
IMMY
BG
DTE
CMA
FTI
LNC IR
EXPD
$10,000M
CB
A
CM
ACE
APC
ETN
AFL
HLT
K
EL
ADP
D
ADBE
BHI
GS
EOG
UTX
MMM
COST
BMO
BNS
AXP
COF CAT
ACN
CNI
IBM
BA
TMO
CI
LO
EIX
AMGN
WAG
CL
BRK.B
AAPL
MA GILD
UPS
TD
HD
CVS
F
SLB
DIS
C
CVX
XOM
BAC PG
JNJ
$100,000M
Market Cap ($)
Source: KCG Data
KCG | MARKET MICROSTRUCTURE 6
Who Gets the Short End of the ‘Tick?
Pilot 3 will force investors to pay exchanges more
exhibit 5: Most “dark” trades are executed
at the NBBO or the mid already.
With the exception of retail and VWAP orders, Pilots 2 and 3 require
trades to be executed at discrete price points—either mid or touch.
25%
Exchange
TRF
We analyzed executions that occurred inside the NBBO for all stocks.
The results are revealing:
20%
Percent of Trades
The dark isn’t as scary as you think
There are two misconceptions about dark trading. First is that it’s all
done in dark ATSs. Second is that it mostly happens at the touch. Data
shows that both beliefs appear to be wrong (Exhibit 5). In fact, we find
that, by value traded:
15%
10%
5%
Ask
80 - 90% of spread
70 - 80% of spread
60 - 70% of spread
Mid
50 - 60% of spread
90 - 100% of spread
Trade Reporting Facility (TRF) at the touch.
40 - 50% of spread
• Only one-third of all “dark prints” are shown to have executed on the
30 - 40% of spread
• But only one-third of those occur at the mid;
20 - 30% of spread
• Two-thirds of all “dark prints1” occur inside the NBBO;
10 - 20% of spread
0
Bid
• Around half of these are on exchange;
0 - 10% of spread
• On average, stocks see around 42% of trades inside the spread;
Source: KCG Data
Good news: Wider spreads should increase depth
Wider spreads should increase the depth of the NBBO, but by exactly
how much is difficult to estimate.
Consolidation of multiple price levels would triple depth.
At a minimum, we should expect that the all the volume currently quoted
inside the 5-cent spreads should consolidate at the new (wider) NBBO.
Based on current book depth (see Exhibit 6) this should almost triple
the depth of book in impacted names. However, if this is all that
happens, investors will be worse off. Traders who sweep the book
now get the same liquidity at cheaper prices thanks to stock that is
displayed inside the 5-cent spread.
Latent liquidity may now be posted
There is a lot of “hidden” volume in today’s market. As each offer is
lifted, volume backfills, often at the same price.
1
Here we define “dark prints” as all exchange prints
inside the NBBO plus all prints on the Trade Reporting
Facility. Note that this excludes reserve and hidden
order types on exchange at the NBBO, which are also
on-exchange dark executions.
KCG | MARKET MICROSTRUCTURE 7
Who Gets the Short End of the ‘Tick?
As spread capture is more important to performance, posting at the
near-touch may become more common.
exhibit 6: Wider spreads should at least
consolidate the lit book out five levels.
Longer queues could draw out liquidity
500
As more volume posts at the touch, queue priority becomes more
important—as the time between posting and executing an order
increases. Smarter algorithms and low-latency infrastructure will
400
be needed to accelerate order submission in order to keep up
Average Shares
with target participation rates. This should add even more liquidity
to the NBBO.
Market makers should be tempted to size up
Market makers try to capture the spread by trading at both the bid
300
200
and the offer. But when a stock gaps up (or down) it causes a loss,
which can trigger stop-loss trading.
For example, in Exhibit 7 the NBBO for the 1-cent spread (orange) gaps
100
outside its range much more frequently than a 5-cent spread (blue).
the market maker to get to the top of the queue. This may reduce the
ASK 5
ASK 4
ASK 3
ASK 2
BID 1
BID 2
ASK 1
However, deeper NBBO has the perverse effect of making it harder for
BID 3
0
BID 5
spread capture to stop-loss trades.
BID 4
The wider spreads make the NBBO less volatile, improving the ratio of
Source: KCG Data
number of trades they get to do if they only post small size. This could
then tempt them to increase their own size.
exhibit 7: Wider spreads should mean more consecutive
trades happen at each NBBO level.
$100.15
$100.10
$100.05
$100.00
1-cent spread
$99.95
5-cent spread
$99.90
Fair price
10:00:35 AM
10:00:30 AM
10:00:25 AM
10:00:20 AM
10:00:15 AM
10:00:10 AM
10:00:05 AM
10:01:00 AM
10:00:55 AM
10:00:05 AM
10:00:45 AM
10:00:40 AM
10:00:35 AM
10:00:30 AM
10:00:25 AM
10:00:20 AM
10:00:15 AM
10:00:10 AM
10:00:05 AM
10:00:00 AM
$99.85
Source: KCG Estimates
KCG | MARKET MICROSTRUCTURE 8
Who Gets the Short End of the ‘Tick?
Bad news: Market impact may also increase
Although depth of book is likely to increase, there will be side effects
exhibit 8: Costs are higher for wider
spread stocks.
that need to be weighed against the benefits of a deeper NBBO. Based
on our comparisons of narrow- and wide-spread stocks in today’s
Transaction costs will increase
When we look at “similar” stock trades (Exhibit 8), we find that
average shortfall is typically higher for stocks with wider spreads.
$0.02
Average Shortfall
market, we expect:
$0.01
$0.00
This should be no surprise as a specific objective of increasing
Narrow
spreads is to increase profits for market makers. That will reduce
returns for other participants.
Wide
Spreads
Source: KCG Data
Signaling and execution risk will increase
Basket is normalized for market cap ($500m
and $750m) trade size (consistent %ADV range),
and volatility (extreme volatility excluded).
As investors try to mitigate the increased costs of trading, their first
Narrow spreads are below 30 bps.
reaction will likely be to capture spread themselves. The problem with
adverse selection longer. The extra wait at near-touch, or cost to cross
10
6
4
2
inside the spread (Exhibit 9).
Ironically, an increase in dark trading is likely to lead
some (including exchanges) to decry the detrimental
impact this has on price discovery and market efficiency.
80%
1
70%
current market. As spreads get wider (in bps), more trades happen
16
60%
simultaneously is to trade in dark pools. This naturally occurs in our
26
50%
The best way to reduce impact, signaling cost and execution risk
42
10%
Dark trading will increase
68
Spread (bps)
the spread, will also make it harder to match VWAP.
100
40%
Longer queues also add to execution risk as orders are exposed to
exhibit 9: Stocks with wider spreads trade
much more often inside the spread (in both
dark pools and exchange dark order types).
30%
it signals your trade.
20%
loading up the bid in order to get priority to capture the spread is that
% Fills Inside Spread
Source: KCG Data
Dark trading percent (x-axis) represents the sum of all
trades printed to the tape at prices inside the NBBO at
the time. This includes exchange and TRF trades.
No doubt this influenced the design of Pilots 2 and 3,
both of which should impede this natural optimization
of trade strategy.
KCG | MARKET MICROSTRUCTURE 9
Who Gets the Short End of the ‘Tick?
Speed will be even more important
As the NBBO gets deeper, capturing spread will take longer, as new
exhibit 10: Book duration increases as
spread increases.
orders join the back of a bigger line (Exhibit 10). This will make speed
some of the spread costs.
Complexity will increase
Different tick sizes for qualifying stocks will make the market
more (not less) complex. The inclusion of three separate pilots
with different routing and limit pricing rules exaggerates this in
the short term.
This seems contrary to one of the overarching concerns about
market structure—that it has become too complex.
Liquidity may decrease
Because the spread is more expensive to cross and book duration is
200k
Quote Turnover (seconds)
even more important for market makers and for investors trying to save
50k
5k
500
50
10
2
1
1
3
5
10
25
50
100
200
400
1000
Spread (bps)
Source: KCG Data
Book duration measures the time (in seconds)
for the average NBBO depth to clear,
based on the ADV of the stock.
Color represents market cap—small-cap
(blue) stocks typically have wider spreads
and slower quote turnover.
likely to be longer, we think total volume traded is most likely to go
down. Wider spreads may make block market making more profitable,
but it’s likely to reduce the ability of electronic market makers to plug
transitory differences in supply and demand for these stocks.
For questions or further information on this report, please contact
Phil Mackintosh at [email protected] or 201.963.2724.
KCG | MARKET MICROSTRUCTURE 10
Who Gets the Short End of the ‘Tick?
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KCG | MARKET MICROSTRUCTURE 11