Brokers Smell Trouble Ahead of Attempt to Spur Smallcap Volume

(This article first appeared on Bloomberg)

Several Wall Street executives expect some turbulence when U.S. markets flip the switch on a program aimed at spurring more volume in small stocks.

Starting Oct. 3, about 1,200 small-cap stocks will have a wider “tick size” — in other words, their prices will be quoted in five-cent increments instead of one cent. The hope is that this two-year test will boost profits for market makers, stimulating volume by luring more middlemen who facilitate trades.

There are signs the industry isn’t ready to comply. Although exchanges have spent years getting ready, tweaking their trading software to accommodate the shift, some investors have been caught off guard, according to an executive from Instinet LLC. That’s a problem because if a money manager’s orders don’t comply with the new rules, they will be immediately rejected.

There’s also concern the cure is worse than the disease. Vanguard Group Inc. Chief Investment Officer Tim Buckley wrote in a 2014 letter that the “unnecessarily complex” pilot doesn’t pass “the most basic cost-benefit analysis.” The firm’s stance hasn’t changed, Vanguard spokeswoman Katie Hirt said.

Market makers may be driven away from the 1,200 stocks covered by the program because of increased risk, said Scott Kurland, managing director at the Investment Technology Group Inc. — an outcome that could undermine the program’s purpose.

Exchanges have complained that liquidity has dried up. NYSE Group and Nasdaq, which along with Bats make up the three big owners of U.S. stock exchanges, support the pilot’s broader strokes. The current U.S. markets aren’t built to help small businesses grow, Nasdaq Global Head of Equities Tom Wittman wrote in a 2015 letter to the SEC.

“Despite there being criticism of it, there’s never been a better idea that someone has proposed to help small-cap companies,” said Brendon Weiss, vice president of the Intercontinental Exchange Inc., which owns NYSE Group.

Fortunato, Bids Trading LP Chief Executive Officer Tim Mahoney and others have made it a mission to caution buy-side traders about the pilot. (Bloomberg LP, the parent company of this news organization, owns a stake in Bids.)

Fortunato said that in April, he realized buy-side investors had no idea about the onerous technical changes the pilot would demand. Since then, Fortunato and Mahoney have seen the buy-side try to align its internal and its technical vendors’ systems to comply. While Fortunato still has reservations, he said he believes the pilot is inevitable at this point.

“The tick-size pilot is in motion, it’s not going to be stopped. There’s no way,” he said.

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