Size matters: US equity market players wrangle over new tick size regime

For all the uncertainty surrounding the upcoming US election, one thing is now clear: there will be a new president in the White House come November. For the Securities and Exchange Commission (SEC), fresh administrations often herald a staffing shake-up, so the pressure is on for the Commission to finalize as many of its planned rules as possible before the winter.

One of the most consequential changes proposed by SEC is an adjustment to exchanges’ tick sizes—the minimum increments for quoting trade prices—as well as the access fees that venues charge market participants to access their quotes. Sources expect that the SEC will present the final rule in late summer or early fall, and market participants and venues alike are trying to understand what the finished product could mean for equity markets.

Eric Stockland, co-head of electronic trading at BMO Capital Markets, says the proposed rule could fundamentally alter market structure, impacting the choices that BMO and other firms make on behalf of their clients. “These changes to the plumbing are like changing the speed limit on the highway: Everybody has to adapt. The rules of the game have changed. Everybody must rethink how they want to behave in this new world,” he says.

These changes to the plumbing are like changing the speed limit on the highway: Everybody has to adapt

Eric Stockland, BMO Capital Markets

While the thrust of the proposal—updating the rules of the road set out in 2005 by Regulation National Market System (Reg NMS)—has been endorsed by a significant portion of the industry, some specific details, such as the exact tick size increments and the value of the cap on exchange access fees, are still the subject of fierce debate.

As it stands, the minimum tick size for stocks worth more than $1 is one cent. The SEC has suggested introducing sub-penny increments for high-volume stocks where the current tick size may prevent market participants from effectively competing on price.

In parallel, the Commission would reduce the cap on fees that exchanges can charge to access protected quotes; another Reg NMS rule says that market participants may not trade at a worse price than the one displayed on exchange without first trying to access that protected quote. 

Since 2005, exchange access fees have been capped at 30 cents per 100 shares (or 30 mils), which equates to 30% of the spread for stocks with a tick size of one cent. The SEC’s proposals would reduce the fee cap to 10 mils.

Even in isolation, these proposals amount to a significant overhaul of the established market structure. When the other equity market reform proposals are added to the mix—including Regulation Best Execution and the Order Competition Rule—the package of rules tabled by the SEC represents arguably the biggest change to US equity market structure since the introduction of Reg NMS in 2005. 

Regulation Best Execution would require broker-dealers to assess all available liquidity sources to find their customers the best price, while the Order Competition Rule would oblige executing brokers to open up retail orders to auctions if they are not able to fill them internally at the midpoint of the best bid and offer.

But while comment letters filed with the SEC highlighted the significant scope of the proposals, market participants largely seem open to discussing the changes. From a trader’s perspective, the tweaks could translate into lower implicit and explicit costs for accessing exchanges—with the potential to save money both on lower access fees and through more aggressive pricing on exchanges.

“The core of the business is to try and reduce implementation costs for asset managers, trading costs for retail investors, and to make the market more efficient. That happens if spreads go down. And right now, they can’t. Stocks can only trade a penny wide,” Stockland says.

Ticks and tech

In its draft rule, the SEC cites improvements in trading and exchange technology as a key driver of the proposed change. “Since the adoption of [Reg NMS], there have been technological advancements that enable trading and order routing systems of market participants to handle the increased message traffic that could occur if smaller or varied minimum pricing increments were implemented for NMS stocks,” the proposal says.

In the 19 years since the current tick sizes and access fees cap were set, trading has fragmented between 16 stock exchanges and a network of alternative trading systems (ATSs). Competition has spurred advances in the matching process, which now takes microseconds rather than seconds, and driven down the cost of accessing some venues.

The exchange access fees cap—which was originally set at 30 mils to keep it in line with the fees that other venues charged in 2005—has now been undercut by many alternative trading venues.

John Ramsay, chief of market policy at New York-based exchange IEX, says that lowering the access fees cap will prevent more established exchanges from seeking rent in return for access to their protected quotes. “All of these efficiencies in trading and technology mean that the cost of actually matching transactions has been dramatically reduced. And ATSs and other markets generally charge much lower prices to access their liquidity. But because participants sometimes have to access exchange quotes, exchanges have much more leverage and authority in terms of pricing power,” he says.

Tick tock

When it comes to implementation, Ramsay says, the adjustment to access fees should be straightforward, as the frequency of pricing changes has got firms in the habit of moving the dial from month to month anyway.

“The half-cent tick size probably requires more lead time for the industry. Because it affects pricing on all exchanges, each firm has to adjust its systems to accommodate it. But having said that, I think we’re talking about maybe a six-month lead time. Given the kinds of technological challenges that firms are used to anyway, it’s not all that big a deal,” Ramsay says.

If tick sizes were reduced (whether to half a cent or to smaller increments, as the Commission initially proposed), firms would have to consider adjustments to some of their models and watch them carefully to ensure that they continue calculating correctly under the new rules.

Stephanie Colling, principal consultant at tech and management consultancy Capco, says that modifying the tick size in each individual model would not be challenging, but that it would be important to ensure that all of a firm’s models were up to date in time for the switch. “In the institutional market banking space, the changes would not be significant. Some of your pricing values would have to change. All the inputs that you’re getting trade confirms from ... valuation or value-at-risk (VaR) calculations would have to be adjusted. But I don’t think it’s a heavy lift on any of those,” she says.

Known unknowns

Market structure experts expect the SEC to publish the final text for the rule by early fall, and they are watching closely to see where the Commission lands on a few contested details.

If they reduce the tick size and then big players win out, it could backfire

Stephanie Colling, Capco

The extent of the reduction in tick size increments, for example, could change the impact of the rule on market structure and liquidity. The SEC has proposed a number of different tick sizes depending on the average bid–offer spread of the stock in question. The most frequently traded stocks would have a 10-mil tick size, followed by 20 mils, 50 mils, and one-cent categories.

For the most part, the industry has supported the 50-mil tick size, but comment letters almost universally opposed the smaller increments. Seventy percent of financial institutions endorsed the introduction of a half-cent tick size in their comment letters, according to data from IEX. 

“We recommend reducing the minimum quoting increment to a half-penny for symbols trading at or above $1 per share that are tick-constrained,” comments from the New York Stock Exchange, Charles Schwab, and Citadel said.

A more pressing question is which stocks exactly will be subject to the half-cent ticks. It will be up to the SEC to determine how widely it spreads the net. The advantage of applying the half-cent tick size to a broader range of stocks is that it would provide more flexibility within the spread. 

For example, if the new tick sizes are applied to stocks with an average spread of two cents, market participants trading within that range will be able to aggress four potential ticks. A narrower application—to stocks with an average spread of just one cent—would limit flexibility to just two ticks within the spread. Whereas the first option would mean a reduced tick size for 80% of the total shares in US equity markets by volume, the second would be closer to 50%.

Capco’s Colling remembers when fixed-income trading platform BrokerTec reduced tick sizes for two-year treasury notes from a quarter to an eighth of a cent in 2018. She believes this change helped the trading population in general by creating more flexibility. “It provided just enough give that you could lift a price, if need be, or it gave a little bit of movement on the intraday spread, so more orders got filled,” she says.

In addition, she says, the change helped make the market more transparent. “Sometimes, the bid and offer was so big that you couldn’t see the participants correctly because there was a good deal of bluffing. With a new tick size, the validity of the order book was improved,” she says.

But Colling cautions that the success of any change to tick sizes in equity markets will depend on the nature of the implementation. “In theory, there’s a rate to being able to go to the next bid. And the more money a firm has, the more it will be able to pick the top spot. These rules are made for the retail investor to have more transparency and a better chance in the market. If they reduce the tick size and then big players win out, it could backfire. But if they pick the right stocks that need more liquidity, just like with the two-year note, it could be great: more participants, more liquidity, more ability to get in and out of the market,” she says.

Because participants sometimes have to access exchange quotes, exchanges have much more leverage and authority in terms of pricing power

John Ramsay, IEX

When it comes to the access fees cap, too, the difference between two seemingly similar reductions—to 15 mils or 10 mils, for example—could have an outsized impact on the way venues operate. IEX’s Ramsay explains that exchanges often use access fees to fund rebates, rewarding liquidity providers for routing their flow to a given venue.

For this reason, Ramsay says, venues will be watching closely to see how far the SEC reduces the access fees cap. “The difference, I think, determines how much wiggle room you leave exchanges in terms of creating pricing tiers. … The more the access fees are reduced, the less flexibility the exchanges have. Obviously, exchanges that are used to paying out large amounts of rebates want more flexibility. Our argument is the more that you reduce it, the more noise you cut out of the system in terms of the complexity of the pricing schedules.”

The 80-odd comment letters submitted by institutions on the SEC’s proposed changes to tick sizes and access fees show some significant dividing lines between the various market players. Broker-dealers and exchanges largely oppose a uniform reduction in access fees to 10 mils, for example, while asset managers are mostly in favor. But all of the comment letters seem to agree on the need for a cautious, thoughtful approach.

“If the proposal comes in, and it’s narrowly tailored, and it really goes after the core of the problem without taking undue risk, then we’d be really excited,” says Stockland. “I think it has the potential to be truly a win-win-win: for venues, brokers, and institutions.”