SEC to End Five-Cent Spreads on Small-Company Stocks

It didn’t receive much in the way of attention, but last week the U.S. Securities and Exchange Commission (SEC) announced its intention to end the pilot program testing five-cent bid/ask spreads. The program mandated minimum quotations and trading increments for stocks of certain smaller companies. It was originally scheduled to expire on October 2, 2018. Since October 2 is a Tuesday, the program will effectively be terminated at the end of next week, on Friday, September 28, 2018.

I expect those of you who invest in smaller-company stocks will be happy to say good riddance to this program. It mandated wider spreads on certain stocks, up to a nickel. Specifically, and as we explained in the June 2015 AAII Journal, the pilot program put selected stocks into one of four groups. Group 1 mandated five-cent quotation spreads, but stocks in this group could trade different price increments. Group 2 stocks traded at five-cent minimum increments but could also trade at the midpoint of the five-cent bid/ask spread. Group 3 stocks had to trade at the quoted price. Stocks in the fourth group—the control group—were not subject to the pilot program’s rules.

The five-cent spread was incurred when transacting in certain stocks for AAII’s model portfolios. Those of you investing in smaller-company stocks likely incurred it too. It was an added transaction cost. It was also an example of legislative intentions not working out in the real world.

The SEC started the program after the House of Representatives passed bipartisan legislation requiring wider stock quote increments on smaller companies. The intent was to boost job growth. Wider spreads were envisioned as drawing attention and investor dollars to so-called emerging company stocks. By widening the spreads, proponents hoped to create a more attractive market for these securities, including more published research about them. It didn’t happen.

Rather (as we’ll discuss in next month’s AAII Journal), “Test-Group stocks generally saw less volume, executed in fewer, larger transactions with less message traffic, short-term order cancellations and quote volatility … Price improvement increased, but not by a large-enough margin to counteract the wider tick, resulting in higher effective spreads,” observed the Financial Industry Regulatory Authority (FINRA) in a report about the pilot program.

Trading shifted away from the major exchanges to other platforms where traders and institutional firms could get better execution prices. This reduced the number of cancelled orders, but also left individual investors—who lacked the ability to control where their orders are filled—paying the wider bid/ask spreads. At the same time, growth in volume for the test group securities “lagged that of the Control Group.”

As explained above, the cost of wider spreads was justified by its proponents as leading to a more active market with more research published about the smaller stocks. In reality, the pilot program “did not appear to increase the number of market makers, on average, in Test-Group securities,” wrote FINRA.

Citadel Securities was more critical in its assessment of the pilot program, as some of you may have read in this week’s Barron’s. Citing data in the FINRA report, the market making firm opined, “Unfortunately for investors, any changes in price-improvement fell far short of countering the increase in quoted spreads. So where did the money go? It appears to have gone to the market makers.”