Panel Advises Against Mandated Spreads for Small-Cap Stocks
Mandating wider bid-ask spreads for small-cap stocks may unfairly hurt individual investors. This was the opinion issued by the U.S. Securities and Exchange Commission’sInvestor Advisory Committee on January 31, 2014. The SEC has been looking into instituting a pilot program to test the effect of wider bid-ask spreads to improve the liquidity of small-cap stocks. The program would potentially involve mandating spreads of five or 10 cents.
The bid-ask spread is the difference between what buyers are willing to pay (the “bid”) and what sellers are willing to accept (the “ask”). Highly liquid stocks trade with bid-ask spreads of a penny. Stocks with lower levels of trading volume tend to have wider spreads. Though low-price and small-cap stocks are most often perceived as having wider spreads, stocks with high share prices can also have wider spreads.
A shift in 2000 to quoting stock prices in penny increments (called decimalization) instead of fractional increments narrowed the spreads. While this has generally resulted in significant cost savings for investors, it has also reduced the revenues realized by market-making firms. This fact is often cited as a reason why efforts need to be made to entice market makers to improve the liquidity of small-cap stocks.
The committee took issue with this stance, citing what they describe as a “chicken and egg” problem. Specifically, committee members questioned whether investor interest in small-cap companies is reduced because there is less information about those stocks available, leading market makers to focus on other sectors. Alternatively, they asked if less market-maker support leads to less information being available. The committee further pointed out that the valuation premium of small-cap companies has increased since decimalization was implemented. At the same time, the committee said no evidence exists showing that market-making firms would provide more research on small-cap stocks if wider spreads were mandated.
Most importantly, the committee raised concerns about the higher transaction costs created by mandating a five- or 10-cent bid-ask spread. They warned, “A government-mandated increase in tick size would subsidize profits for the most sophisticated financial participants at the expense of retail investors.”
At press time, it is uncertain as to what the SEC will or won’t do in light of the committee’s recommendations. Some industry groups are pushing for the implementation of the pilot program, though the SEC could alter it before launch.
Source: “Recommendation of the Market Structure Subcommittee: Decimalization and Tick Sizes,” U.S. Securities and Exchange Commission, January 31, 2014.