Critics strike back at tick-size pilot program

(updated with correction)

The inclusion of a trade-at provision in the SEC's proposed small-cap tick-size pilot program is proving controversial, with debate centering on whether it unfairly targets dark pools and makes the overall program too complex.

The proposed one-year pilot program, released for a 45-day comment period that began Nov. 3, has a test category with the trade-at provision, under which stocks for companies valued at up to $5 billion must trade on a lit exchange unless the sellers can prove they can get a better price on another venue, such as a dark pool.

The other two categories — shares quoted at 5-cent increments but traded in pennies, and shares both quoted and traded in 5-cent increments — do not require best-execution proof to use a venue; the pilot program also has a control group trading shares in penny increments.

No start date has been set.

What has some consultants and money managers concerned is that the pilot program was created by lit exchange operators including NYSE Group and Nasdaq OMX Group Inc., and that the trade-at provision was added to serve their interest alone.

“My gut assessment: There are advocates for both sides on the trade-at rule, but the exchanges that advocated trade-at had a receptive audience at the SEC,” said Steven Glass, president and CEO at Zeno Consulting Group LLC, Washington, a boutique consultant firm that monitors trading issues on behalf of asset owners. “My theory is that to just widen the spreads without the trade-at rule could turn even more people to dark pools. If the SEC is ultimately concerned about the integrity of the markets, they have a strong preference toward transparency — and that means lit exchanges.”

Mr. Glass cited a June speech by Mary Jo White, Securities and Exchange Commission chairwoman, in which she related concerns about both the increased trade flow to dark pools and how to expand the small-cap equity market.

“In my mind, she was already combining the two,” he said. “The first time I saw the SEC formally discuss the trade-at rule was in a 2010 concept release. In that, there was not one reference to small-cap stocks. It's hard to say how transparency and small-cap liquidity were linked.”

Dark pools are protected in the pilot program as proposed; there are exemptions in all test categories for block trades and for trades executed at midpoint, said Jamie Selway, managing director and head of electronic trading at brokerage and financial markets technology provider Investment Technology Group Inc., New York. ITG operates a dark pool.

But if changes were to be made when the pilot program goes live, that would create universal trade-at provisions for all trades, “That would be really bad for institutions,” Mr. Selway said. “That would go against the statutory mandate of the SEC to get best execution.”

Henry Yegerman, director of trading analytics and research at financial data provider Markit Group Ltd., New York, questioned the motivation behind including a trade-at provision in the test. He also voiced concern about its impact on trading costs.

“The real question is, who gets something out of putting the trade-at rule in regulation?” Mr. Yegerman said. “The exchange owners? Well, duh! Who would have thought? Let's assume it's not just self-interest. Who will benefit other than the lit markets? It won't be the market makers. Also, there's an increase in trading cost to find someone that will trade at a half-penny higher. The metric (in the test) may not measure what (the SEC) wants to measure. Price improvement is not the same as lower trading cost. This test will mean better spreads but also more executions, with possibly higher cost.”

NYSE Group officials in a statement said the tick-size pilot program — including the trade-at provision — should broadly benefit investors. “The tick-size pilot will test alternatives for building better quality markets for smaller public companies, and success could come in the form of greater market-maker participation, increased displayed liquidity, improved fill rates and less price volatility,” according to the NYSE statement. “We believe pilots can be a useful source to collect data and analyze market structure changes, and we support the SEC moving forward with other pilots to test alternative market structures for the entire equities market.”

Officials at Nasdaq did not return repeated calls for comment.

Not all of the exchanges that signed off on the tick-size pilot agree the trade-at provision should be included. Said Joe Ratterman, CEO at BATS Global Markets LLC, Kansas City, Mo.: “We resisted (trade-at) at first, but the SEC asked for a plan, and we decided that we would sign off on it even though there were elements in it we didn't believe in.”

BATS will submit its views to the SEC during the comment period, Mr. Ratterman said.

“Trade-at would unnecessarily disrupt the market ecosystem,” Mr. Ratterman said. “From our viewpoint, we advocate what's best for all markets and all investors. Right now, investors can seek a number of venues on which to trade, and dark pools are a great place to find liquidity without causing potential effects on the market. Trade-at would be a regulatory sledgehammer that would take trading options away from the investor.”

BATS does not operate a dark pool but does route some orders on the direction of investors to dark venues.

In Europe, a rule requiring price improvement to trade in a dark pool is included in the Markets in Financial Instruments Directive II, which standardizes financial service markets across European Union members, including requirements for pre- and post-trade transparency.

“In Europe, technically, there are going to be volumes now traded in the dark that you won't be able to do anymore,” said Brian Schwieger, head of equities, London Stock Exchange Group, London. “European regulators have the view that dark pools were reserved for larger block trades. But the average trade size for dark pools in Europe are about the same as the lit markets, so the regulators see no reason for smaller trades in dark pools and believe there'll be no market impact” from pre-trade transparency.

For Ryan Larson, head of U.S. equity trading at RBC Global Asset Management (U.S.) Inc., Chicago, the complexity of the tick-size pilot with the trade-at provision is a head-scratcher.

“The pilot program is too complex, too short-term, too costly,” Mr. Larson said. “I'm not sure what the data will look like at the end of next year. Regulators should decrease the complexity of test group three (which includes the trade-at provision). Maybe they need to back off of trade-at altogether. Maybe there should be a pilot trade-at test for all stocks, not just small caps. Maybe the SEC needs to look at an all-cap trade-at. The small-cap tick size test gave (exchanges) an opportunity to do this when the exchanges and (the Financial Industry Regulatory Authority) were told by the SEC to come up with a plan” to improve small-cap stock liquidity. “The pilot started one thing and turned into something a lot more complex.”

Markit's Mr. Yegerman said that, as a result of an overly complex pilot program, the test data “could be skewed. It would be better to do a separate trade-at test. ... Intellectual hygiene means being able to control the test. As is, the results of (the tick-size pilot) will be inconclusive. They've hit such an innocuous group of stocks and put them under the veil of improved funding for small business. It ends up they could be creating another unintended result.”