On May 6, 2015, the Securities and Exchange Commission (SEC) approved a joint plan to be entered into by the Financial Industry Regulatory Authority (FINRA) and the US exchanges for implementing a pilot test to analyze the effects of wider minimum quotation increments on market quality for stocks of smaller companies. The tick test pilot will begin within one year – by May 6, 2016, and will last two years (originally proposed to be one year). The one-year implementation period is intended to provide sufficient time for the development and testing of compliance systems for the pilot.
The SEC’s original order directing that the plan be established was issued on June 24, 2014, and the plan was published for comment on November 7, 2014.
Some believe that penny quotation increments have deterred liquidity providers from displaying visible liquidity since order flow has been directed to internalizing market makers that pay retail brokers for order flow and execute trades at or with very minimal price improvement to displayed quotations. It is speculated that a wider displayed increment will increase liquidity by improving the incentive to quote publicly and make it more expensive to internalize orders. The fundamental question, however, is whether wider quotation increments will enhance liquidity by promoting more active market-making or simply drive up trading costs.
The pilot will include stocks of companies with a market capitalization of $3 billion or less (originally proposed to be $5 billion or less); an average daily trading volume of one million shares or less (as proposed); and a volume weighted average share price of at least $2 per share for every trading day. The pilot will include one control group of approximately 1400 securities and three test groups with 400 securities in each. The key features of these groups are as follows:
- Pilot securities in the control group will be quoted at the current penny tick size increment, and trade at the increments currently permitted.
- Pilot securities in the first test group will be quoted in $0.05 minimum increments. An exception would be provided for orders entered at the midpoint of the quotation range and for certain retail liquidity programs. Trading would continue to occur at any price increment that is permitted today.
- Pilot securities in the second test group will be quoted in $0.05 minimum increments, and traded in $0.05 minimum increments subject to certain exceptions. Exceptions include orders entered at the midpoint of the quotation range, retail orders with price improvement of $0.005 better than the best quote and for negotiated trades at other prices.
- Pilot securities in the third test group will be subject to the same minimum quoting and trading increments as the second test group, and the same exceptions, but in addition would be subject to a “trade-at” requirement that would operate during regular trading hours. In general, the “trade-at” requirement prevents price matching with respect to protected orders by a trading center that is not quoting at the protected price, and where matching is permitted, it is only permitted up to the displayed size quoted at the protected price. Exceptions to the trade-at requirement include retail orders with price improvement of $0.005 better than the best protected quotation and for block-sized or negotiated trades, among other exceptions. “Block size” for the purpose of the exception was reduced to an order (1) of at least 5000 shares or (2) with a market value of at least $100,000 – half of the levels that were proposed.
Although some commentators suggested that including Canadian-based interlisted securities in the pilot could promote regulatory arbitrage, the SEC responded by indicating that these securities were included in other National Market System rules, and will not be excluded.
The pilot also directs the exchanges and FINRA to collect and transmit data to the Commission and make the data available to the public in an agreed-upon format. After the end of the pilot period, the exchanges and FINRA will complete an assessment of the impact of the pilot and submit the assessment to the SEC. The exchanges and FINRA will submit their initial assessments 18 months after the pilot begins based on data from the first 12 months.