Big Ticks Hold Small Caps Hostage

Do bigger trading increments benefit small companies, or just the investment banks and market makers? Looking at the groups lined up behind nickel and dime trading, the bankers and markets.

To review, US markets moved to decimalization to improve liquidity. European markets are trying to move towards uniform trade sizes. Why would some market participants want to move US small caps in the other direction? I think the simple answer is more money in their pockets.

How exactly would nickel and dime trading help small caps? Trades take place on a market where the two parties are not connected to the company. If I want to buy Chimerix, I buy it from someone who already owns it, not the company. The company stops being interested in the marketplace for its stock as soon as it floats the IPO or subsequent stock offering. At that point, the company has all the money it will ever get for its stock, and it got the money from the offering syndicate of investment banks, not the market.

So where is the company’s interest advanced by changing the tick size? It must come at the point when the company management is negotiating with the syndicate and the market that is considering listing the company. While big name IPOs such as Facebook and Twitter might hold significant leverage in these talks, most small companies do not have significant leverage, and have to take the deal offered to them.

I can imagine that if the wider tick size rules go into effect, that the conversation will go like this:

Banker: If you agree to have your stock traded in nickels, we’ll price your IPO $50 million higher.

Management: I lose nothing and get $50 million, sounds like a good deal.

Well, the bankers are not a charity. That $50 million is going to come from somewhere. Enter the retail investor!

Invoking job creation at small companies is just putting lipstick on the pig. Wider tick sizes enriches the market maker at the cost of somebody else. The bankers and markets are bribing the managements to go along.

You’d think the SEC, who’s mandate it is to protect the individual investor, would be all over this. You’d be wrong.

I’d be happy to be wrong about all this, but I have yet to hear a coherent explanation of the cause and effect that wider tick sizes will lead to job creation in small caps.

What I see as part of the problem is a lack of countervailing power between the small company and the banking syndicate. What could change that? Perhaps small companies should come together and negotiate their IPOs as a group – take us all public, or none of us. There is safety in numbers, and they could negotiate from a position of power.

It is also true that the company management has no incentive to care for the trading of their stock, except for when they want to cash out of their stock options. At that point, they should be treated like any retail investor. Perhaps then they will realize that they are putting money in someone else’s pocket.

I strongly believe in small company participation in the capital markets. The broadest equity funds are the best for long-term capital appreciation – that is the conclusion of multiple studies. If the SEC wants to protect the individual investor, they would help make it easier for small companies to tap the capital markets without enriching the middleman, and get retail investors to buy the resulting broad index funds.

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