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Joe Saluzzi

Themis Trading LLC

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Market Surveillance 2.0: Beyond the Crisis

27 August 2014

Is Test Group 3 of the Tick Size Pilot Program Being Set Up To Fail?

A list of exceptions added to the Trade-At prohibition test group could threaten the integrity of the SEC’s wide-tick pilot program.

We are happy to see that progress is being made on the tick size pilot program. Two months after the SEC instructed the exchanges and FINRA to submit a plan for the one-year wide tick pilot program, the exchanges and FINRA have complied. However, the plan does provide some new exceptions that do worry us (more on those later).

[Related: “A Nickel for Your Thoughts: The SEC Tick Size Pilot Program”]

Just to refresh your memory, here is what the SEC proposed:

“The pilot program will include stocks with a market capitalization of $5 billion or less; an average daily trading volume of one million shares or less; and a closing share price of at least $2 per share. 

The pilot will consist of one control group and three test groups with 400 securities in each test group selected by stratified sampling.

  • Pilot securities in the control group will be quoted at the current tick size increment of $0.01 per share, and trade at the increments currently permitted. The control group would represent a baseline for analysis during the pilot period.
  • Pilot securities in the first test group will be quoted in $0.05 minimum increments. 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.
  • Pilot securities in the third test group will be subject to the same minimum quoting and trading increments (and the same exceptions) as the second test group, but in addition would be subject to a ‘trade-at’ requirement. In general, a ‘trade-at’ requirement prevents price matching by a trading center that is not displaying the best bid or offer.”

The 45-page plan, which was submitted by the exchanges and FINRA, provides more details about the tick size pilot program, including a detailed section explaining which type of data will be required to get collected and analyzed. This is encouraging since we know the program will be studied carefully and future policy decisions will hinge on this data.

We are, however, very concerned about a list of new exceptions published by the plan. We believe that for the wide-tick size pilot program to be properly evaluated it must remain as pure as possible. This means having as few as possible exceptions to the new rule.

Of the pilot programs test groups, Test Group 3 has been the most controversial since it contains a trade-at prohibition. It’s no secret that certain groups in the industry fear that a trade-at rule might be proposed for the entire stock market if Test Group 3 proves to be successful. If trade-at were implemented across the stock market, it is likely that some business models would suffer immensely.

The exchanges and FINRA added 13 exceptions to the Trade-At prohibition test group. This surprised us since we thought the exchanges would not want many exceptions to the trade-at provision as it would drive some off-exchange volume back to the exchanges. Some of the more-curious of the 13 trade-at prohibition exceptions include:

(7) The order is executed when a protected bid was priced higher than a protected offer in the Pilot Security

(8) The order is identified as an Intermarket Sweep Order;

(9) The order is executed by a trading center that simultaneously routed Trade-at Intermarket Sweep Orders to execute against the full displayed size of the protected quotation that was traded at;

11) The order is executed when the trading center displaying the protected quotation that was traded at had displayed, within one second prior to execution of the transaction that constituted the trade-at, a best bid or best offer, as applicable, for the Pilot Security with a price that was inferior to the price of the trade-at transaction.

(12) The order is executed by a trading center which, at the time of order receipt, the trading center had guaranteed an execution at no worse than a specified price (a “stopped order”)

We wonder why so many exceptions have been written into Test Group 3? Is this group intentionally being set up to fail?

One other thing that also still concerns us is that the Tick Size Pilot Program will only be implemented on a one-year pilot basis. We hope this is enough time to generate the data that is needed to fully analyze the program before any judgment is made by the SEC.

We’re going to take a closer look at this plan and possibly issue a comment letter on it. If you want to do the same, you have 21 days to post your comment.

This commentary originally appeared on the Themis Trading blog.

Spotlight-white-trans For more stories in the Market Surveillance 2.0: Beyond the Crisis Spotlight Series click here.

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3 Comments to "Is Test Group 3 of the Tick Size Pilot Program Being Set Up To Fail?":
  • Comment_tabb_-_larry_tabb_hi-res_wo

    27 August 2014

    Interesting - nice piece - now help me understand these

    7) is a crossed market - that is just a messed up market and I can understand not routing.

    8) an ISO - why would an ISO be exempted? I guess because an ISO means that the broker is accepting routing authority so the exchange shouldn't route. that kind of makes sense.

    9) Does this mean that if I am exchange A and I routed an order to exchange B for the full quote - that if I get another order, there is no need to route it to exchange B cause I theoretically took out the liquidity at exchange B? That kind of makes sense.

    11 & 12) I have no clue what these mean

    Am I right here? Can anyone provide insight?

  • Missing

    28 August 2014

    Larry,  you are correct.  Because Trade-At is trade-through on steroids, the rule needs to recognize similar exemptions found in Reg NMS's Trade Through rule (eg, ISOs).  Also, by tracking these similar Reg NMS exemptions, technical implementation may be somewhat simpler.  

    I am also looking forward to the discussion regarding which market data feeds can be used for compliance with the Trade-At rule (SIP or direct feeds).  

  • Missing

    29 August 2014

    FYI I personally think this entire program is being set up to fail.  1. I already trade small cap stocks that have .30-.40 spreads.  Spread size has absolutely nothing to do with liquidity or the lack of coverage or the lack of new issues.  Since everything trades on an agency basis, there is no spread to capture.  Brokerage houses don't put out research on small cap companies because they don't have enough shares outstanding.  Companies are also not splitting their stocks as much, less shares to trade, less commision dollars.  There are less companies comming public due to massive regulations and more venture capital and angel investors that are keeping companies private longer.  It has nothing to do with spreads.  So bottom line, i truely believe that this entire program is set up to fail since the only thing it might help, is to reduce some of the preditory HFT Stratigies, since they won't want to take on the risk associated with a wider spread. 

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