Thinking

Tick Pilot 2016: Make Small Caps Great Again

August 31, 2016 Philip Pearson

SUMMARY

• Tick pilot affects all stocks under $3 billion market cap with ADV < 1 million shares
• Control group and three test groups will be announced on Sept. 2, 2016. Pilot begins Oct. 3, 2016. Will run for two years.
• More than 40% of tick pilot symbols have average spreads under $0.05.
• More than 30% of trading in tick pilot names occurs at prices that will no longer be allowed in Test Groups 2 and 3.
• For a basic summary on how ITG is handling the tick pilot requirements, see Tick Size Pilot Considerations

The time for talk is over. On Oct. 3, 2016, after several years of spirited discussion, the Tick Size Pilot Program is finally coming to U.S. equity markets. Originating in Congress as part of the 2012 JOBS Act, the stated goal was stimulating IPOs and research activity among small-capitalization companies in an effort to create jobs. The theory is that by increasing the incentives to make a market in these stocks with wider spreads and less volatility, banks will be more likely to provide research and underwriting for small companies. This effort has morphed into a broad experiment on U.S. equity market structure.

In the final incarnation, the experiment has a few different objectives. First and foremost is the stated intent of increasing small-cap liquidity. Proponents believe a wider ($0.05) spread will lead to more displayed liquidity and thus an easier trading regime. The additional elements of the pilot, namely trade increment restrictions and “trade-at” rules, seem to be unrelated to the primary goal. The focus of these add-ons is whether the proliferation of off-exchange (dark pool) trading has a negative impact on the equity market quality. As ITG and many other market participants argued, the complexity of the project dilutes the original intention.

Much has been written about the methodology and goals of the tick pilot, so we will be brief in our high-level summary. It is no longer a question of how exactly the pilot will look but rather what the effect will be. We are interested in evaluating impending changes to trading patterns and liquidity caused by the pilot. We offer an empirical study of historical data from Q1 2016 to compare the potential effects on pilot stocks. Additionally, we analyzed trading in ITG’s algorithms in the pilot stocks to see any trends that could prove informative going forward.

This is not just a tiny corner of the market. While individually these stocks are illiquid, in sum they add up to about 11% of all U.S. equity trading. That’s more than 600 million shares trading per day. It’s time to get ready. Now, traders, exchanges, market makers and other industry participants are racing to get the infrastructure in place to accommodate the new rules.

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