In June, the Securities and Exchange Commission (SEC) directed that the US exchanges and the Financial Industry Regulatory Authority (FINRA) propose a joint plan for implementing a pilot test to analyze the effects of wider minimum quotation increments on market quality for small cap stocks. On August 27, the SEC published this joint plan with a 21 day comment period.
Some believe that penny quotation increments have deterred liquidity providers from displaying visible liquidity since order flow has been directed to internalizing market makers that pay retail brokers for order flow and execute trades at or with very minimal price improvement to displayed quotations. It is speculated that a wider displayed increment will increase liquidity by improving the incentive to quote publicly and make it more expensive to internalize orders. The fundamental question, however, is whether wider quotation increments will enhance liquidity by promoting more active market-making or simply drive up trading costs.
The small caps stocks selected for the pilot will have a market capitalization of $5 billion or less; an average daily trading volume of one million shares or less; and a closing share price of at least $2 per share. The pilot will have one control group and three test groups with 400 securities in each. The key features of these groups are as follows:
- Pilot securities in the control group will be quoted at the current penny tick size increment, and trade at the increments currently permitted.
- Pilot securities in the first test group will be quoted in $0.05 minimum increments. An exception would be provided for orders entered at the midpoint of the quotation range and for certain retail liquidity programs. Trading would continue to occur at any price increment that is permitted today.
- Pilot securities in the second test group will be quoted in $0.05 minimum increments, and traded in $0.05 minimum increments subject to certain exceptions. Exceptions include orders entered at the midpoint of the quotation range, retail orders with price improvement of $0.005 better than the best quote and for negotiated trades at other prices.
- Pilot securities in the third test group will be subject to the same minimum quoting and trading increments as the second test group, and the same exceptions, but in addition would be subject to a “trade-at” requirement. In general, a “trade-at” requirement prevents price matching by a trading center that is not displaying the best bid or offer. Exceptions to the trade-at requirement include retail orders with price improvement of $0.005 better than the best protected quotation and for block-sized or negotiated trades, among other exceptions.
The pilot also directs the exchanges and FINRA to collect and transmit data to the Commission and make the data available to the public in an agreed-upon format. After the end of the pilot period, the exchanges and FINRA will complete an assessment of the impact of the pilot and submit the assessment to the SEC.