Wall Street’s preference for low-priced stocks
Three weeks ago, Alex Tabarrok found an intriguing post by high-frequency trader Chris Stuccio. The idea is very elegant: if you want to stop high-frequency traders extracting rents from the market, there’s an easy way to do so — you just allow stocks to trade in increments of much less than a penny. Matt Levine puts it well: right now, he says, “because you can’t be outbid by another bidder within the same penny increment, you get free money by just getting there first”. If high-frequency traders could compete on price rather than just on speed, then a lot of the silly arms-race stuff would be replaced by better prices for investors.
It’s a serious proposal, so I was glad to see that Matthew Philips wrote it up for Businessweek. But after starting off well, Philips ends up joking about it, and refusing to adjudicate between Stucchio and his on-the-other-hand trader, Ben Van Vliet.
The fact is that on the face of things, Stuccio is undeniably correct. Here’s the chart, from Credit Suisse via Cardiff Garcia:
The y-axis shows the bid-offer spread on any given stock, in basis points; the x-axis shows the price of the stock, in dollars. Clearly, there’s an artificial clustering around that curve. For a lot of stocks trading at less than $50 a share, the market would happily provide bid-offer spreads of less than a penny if it could; but it can’t. And when stocks get really cheap, the bid-offer spread becomes enormous. For instance, an eye-popping 3.766 billion shares of Citigroup were traded on December 17, 2009, when the stock fell 7.25% to $3.20. At that level, a one-penny bid-offer spread is equivalent to a whopping 31 basis points; if Apple traded at a 31bp spread, then its bid-offer spread would be almost $2.
Clearly, the traders were the big winners when Citi was trading at a very low dollar price — if you make the assumption that traders capture half the bid-offer spread on each trade, then the traders made almost $20 million trading Citigroup alone, in one day.
On the other hand, it seems that the market almost never trades stocks at a bid-offer spread much below 2bp. Which in turn means that for stocks over $50 per share, we’re pretty much already living in Stuccio’s ideal world, where the spread is determined by traders, rather than by an artificial rule barring increments of less than a penny.
Which brings me to my theory: that companies deliberately price their shares at less than $50, as a way of greasing their relationship with Wall Street a little bit. Back at the end of 2010, I was very confused by the fact that Facebook had done a 5-for-1 stock split, reducing its share price from about $75 to about $15. But in hindsight, maybe it was all part of its IPO preparations: you almost never see stocks go public at more than $50 per share.
Here’s a question for the data geeks out there: did nominal share prices decline after the stock market moved to penny pricing in 2000? If so, that would support my argument: that Wall Street manages to engineer stock prices so that it makes good money trading shares. And companies are generally happy to go along with Wall Street on this: most stocks trade at $50 per share or less.
It’s true that a lot of the rents from the sub-penny rule and low nominal share prices are captured not by Wall Street proper but rather by HFT shops. But all Wall Street banks have some kind of HFT operation of their own, and in general it’s probably fair to say that the lower the nominal share price, the more money that Wall Street makes. And conversely, the higher a company’s nominal share price, the less beholden it feels towards Wall Street.
To put it another way: the sub-penny rule is a way of allowing companies to price their stock so that Wall Street can make good money trading it. And we don’t need Stuccio’s rule, since it can effectively be implemented just by pricing your stock above $50 per share. If the companies don’t want to subsidize Wall Street, all they need to do is price their stock higher. And if companies do want to provide this hidden subsidy to Wall Street, maybe they should be allowed to do so.