Opinion

Felix Salmon

Why dedecimalization is a bad idea

By Felix Salmon
May 14, 2013

Dan Primack is excited about a new bill which would give small-cap companies the option to have their stocks be quoted at 5-cent or 10-cent increments rather than the standard one-cent gap. He explains:

Small-cap stocks are trapped in a cycle of arrested development. They are small, so they are ignored by analysts and market-makers. And because they are ignored by analysts and market-makers, they remain small.

The first part of this is surely true: analysts and market-makers do tend to ignore small-cap stocks. But from there on in, things start getting very sketchy. For one thing, there’s no evidence that if you’re ignored by market-makers, your company finds it harder to grow. Even today, in order for a company to grow, it needs more than just a fluffy stock price: it also needs things like increasing profits, or revenues. And while higher profits can feed quite easily into a higher share price, the causality is much harder the other way around — having a high share price doesn’t particularly* help you grow, especially if you’re not interested in acquisitions.

So the premise here is pretty unconvincing to start with: the idea that if we get more analysts and market-makers to cover a particular stock, that will help publicly-listed small-cap companies grow. But there’s a hidden premise here as well, which is even less convincing: that if we allow stocks to be quoted in increments of 5 cents or 10 cents, that will improve the quantity and quality of the market support those companies receive.

One of the good things about the world is that the world of stockbrokers is in secular decline. Americans are — finally — beginning to realize that discount brokers and ETFs and index funds are much more sensible ways to invest than the old method, where a friendly sales guy from Merrill Lynch would chatter away about this stock and that stock and eventually charge you an enormous commission for the privilege of buying or selling at what was invariably exactly the wrong time.

Congressman David Schweikert, who is putting forward the new bill and who represents Scottsdale, Arizona, is puzzled that the SEC has done nothing on tick sizes, despite “overwhelming evidence that wider ticks for small-cap companies will stimulate liquidity, encourage capital formation, and grow jobs”. But I for one haven’t been overwhelmed by any such evidence, and the people pushing it seem to be exactly the industry insiders who would make lots of money from it.

The Schweikert bill is particularly interesting because it doesn’t actually decimalize the small-cap stocks in question. Instead, it quite explicitly just funnels money from small investors to bigger investors and brokerages. Here’s the key bit, with my emphasis added:

The Spread Pricing Liquidity Act allows companies with public float of less than $500 million and average daily trading volume under 500,000 shares to select to have their securities quoted at increments of either 5 or 10 cents, while maintaining trading between the quoted ticks.

Essentially, what this does is disembowel the wonderful NBBO system which has done more to protect small investors than anybody else. NBBO, which stands for National Best Bid/Offer, is the system whereby all of the stock quotes on all of America’s exchanges are aggregated, so that all investors can at any time see the very best bid and the very best offer for any stock. If you’re a small investor, these days, you can pretty much always get immediate execution at NBBO, the best price in the market. The combination of decimalization and high-frequency trading has, in the words of former SEC commissioner Arthur Levitt, “transferred billions of dollars from the pockets of brokers into the pockets of investors;” for the first time ever, small investors get the best execution in the market, rather than the worst.

(This, incidentally, is one of the reasons why it’s hard to write about the problems with high-frequency trading for a generalist audience — there’s no Wall-Street-is-ripping-off-the-little-guy angle, for all that everybody would love to find one.)

Under the Schweikert bill, however, all that goes away. While the brokers and the algobots will still continue to trade in penny increments, smaller investors — and quite possibly bigger investors, too — will only see prices quoted in multiples of 5 cents or 10 cents. For instance, say a stock is quoted at $13.35/$13.40. If you put in a buy order, you’re going to pay $13.40. But the real trading will be going on inside the spread, and your broker can go into the market and snap it up at $13.38, while you still pay the higher price. There’s no way that small investors can possibly benefit from this.

Will brokers take the rents they extract from small investors and reinvest them in deeper coverage of small-cap companies? That’s the hope, but I’m not holding my breath. In a shrinking market, they’re much more likely to hold on to their profits as much as they can. And besides, it’s not like companies need David Schweikert to come to the rescue if what they want is a wider bid-offer spread: all they need to do is have a stock split.

Schweikert was one of the prime movers behind the problematic JOBS Act, where the SEC has done a good job of stalling on various silly yet Congressionally-mandated reforms. This bill seems like a replay: Schweikert wants to force the SEC’s hand on dedecimalization, since the agency is being sensible and dragging its feet. I hope he fails.

*Update: Primack points out that a higher share price can be helpful if companies want to raise subsequent equity rounds, after they’ve gone public.

Comments
6 comments so far | RSS Comments RSS

David Schweikert is just a shill for the financial industry. Case closed.

This is an unmistakably terrible idea.

Posted by QCIC | Report as abusive
 

Felix – I think de-decimalization is a terrible idea, and I think that this post is almost completely spot on, except for one thing: I may be wrong, but I don’t think this is accurate:

” For instance, say a stock is quoted at $13.35/$13.40. If you put in a buy order, you’re going to pay $13.40. But the real trading will be going on inside the spread, and your broker can go into the market and snap it up at $13.38, while you still pay the higher price.”

If the stock is “offered” somewhere that your broker can see for 13.38, you should still get that fill. The problem is that with fragmented markets, and undisplayed liquidity, it’s harder to get that 13.38 stock, because you have to be at the right market center and “get lucky” since it’s probably not displayed (which is the whole point of the bill)

Posted by KidDynamite | Report as abusive
 

I have an idea: let’s mandate that brokers make locked market for unlimited size! The fed can just print money to make up the brokers loss so everybody will be happy!

Posted by UpHillStill | Report as abusive
 

I understand the desire to bring back the days of Alex. Brown, Hambrecht & Quist and other such firms that specialized in making markets for small stocks. It certainly was a good time for small companies and lots of people got rich. And one reason they got rich was that Nasdaq market-makers were gouging investors by fixing prices — quoting prices of, say, $10 1/4 for a share when the real price was $10 1/8. It was a big scandal at the time, but no one seems to remember it now and who can blame the folks who want to bring back fractional prices for reminding us. But here’s the Justice Department press release about the matter:

http://www.justice.gov/opa/pr/1996/July9 6/343-at.html

Posted by IntheMkts | Report as abusive
 

I think Schweikert is right. David Weild and Edward Kim have done the best research I know of in this area. They point out for example that looking at the decade of the 1990s as a whole, the average annual number of IPOs was 520. If one makes the reasonable assumption that the number of IPOs each year should increase in a way proportionate to the growth of the broader economy, then in 2011 the US would have had 950 such offerings. If fact, it had roughly 1/6th of that number.

http://www.gt.com/staticfiles/GTCom/Publ ic%20companies%20and%20capital%20markets  /gt_wakeup_call_.pdf
The US stock market as a whole is shrinking. The number of companies that have left it every year since 1997 has surpassed the number entering. Nothing goes public today in the US markets that isn’t worth several hundred million dollars. It was not always thus — in the days of fractional stock prices it was not thus. Intel went public in October 1971 for a market valuation of but $6.8 million.

The shriveling up of the IPO world is an outward and visible sign of an inward and invisible disgrace: Wall Street is malfunctioning. It doesn’t work as a way to do what we do need a system for doing — a way of getting the money of savers into the hands of entrepreneurs.

Posted by Christofurio | Report as abusive
 

“Americans are — finally — beginning to realize that discount brokers and ETFs and index funds are much more sensible ways to invest than the old method, where a friendly sales guy from Merrill Lynch would chatter away about this stock and that stock and eventually charge you an enormous commission for the privilege of buying or selling at what was invariably exactly the wrong time.”

Strange that Americans haven’t got richer, with all these great developments, isn’t it? Specifically, the evidence has pretty much piled up that without that friendly sales guy, middle class American saving has absolutely cratered. Non-selling is a much bigger problem than mis-selling, but the regulators never look at that because it’s not a problem that can be blamed on anyone.

Posted by dsquared | Report as abusive
 

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