Cboe Proposes Tick-Reduction Framework to Ensure Market Structure Benefits All Investors
At Cboe, we strongly believe that fair and competitive markets provide a level playing field for all participants. As the U.S. Securities and Exchange Commission (SEC) explores equity market structure changes, we believe it is important that any resulting reforms are measured, evidence-based and truly beneficial to all investors.
Minimum pricing increment, or tick size, is one of the key components of the current U.S. equities market structure reform effort. Current Regulation National Market System, or Reg NMS, Rule 612 dictates that the minimum quotation increment for securities quotations of $1.00 or more is one cent. There is growing concern among some market participants that the present structure contributes to an uneven playing field and market inefficiencies. In particular, many argue that securities trading is sub-optimal due to Rule 612’s one cent minimum pricing increment and that a finer increment would greatly enhance the investor experience. However, analysis from Cboe’s North American Equities Execution Consulting team found that a sweeping one-size-fits-all increment change could potentially introduce other inefficiencies in the marketplace. Instead, Cboe proposes a more targeted alternative tick framework that we believe can more precisely address truly tick-constrained securities and fuel competition between trading venues without introducing unnecessary risk and operational complexity to the U.S. equities markets. In our analysis and subsequently proposed framework, we consider whether all securities are truly tick-constrained, the danger of a one-size-fits-all approach and how objective criteria that focuses on constraint, cost and liquidity may enhance equities market structure.
Are all securities tick-constrained?
The current artificial tick-constraint of securities is one of the drivers for potential amendment to Reg NMS Rule 612.. To determine the validity of this stance, our team examined the National Best Bid and Offer (NBBO) of all NMS securities, including Exchange Traded Product (ETPs), from January 3, 2022, to August 23, 2022 with a focus on regular trading hours, from 9:30 a.m. ET to 4:00 p.m. ET. We excluded opening and closing auctions, as well as locked and crossed markets because we do not consider these markets to be representative of regular trading activities. We also only examined securities above $1.00, the primary focus of investors’ expressed tick-constrained concerns. Within these parameters, we calculated the simple average quoted spread of each security based on the NBBO quotes, as shown in Exhibit 1 below. We believe this data sample is representative of regular trading activities.
Our results show that out of 10,125 securities, only 9% (877) should be considered preliminarily tick-constrained —those with an average quoted spread of 1.1 cents or less (Exhibit 1). Further calculations of their respective notional value traded shows that these 877 securities represent 49% of average daily volume (ADV) and 22% of average daily notional value (ADNV) traded. Indeed, both measurements show that 88% of NMS stocks are quoted at spreads above 1.5 cents. Furthermore, on the right-hand side of the distribution, 37% of securities representing 25% ADNV are being quoted at spreads above 10 cents. This result invalidates the claim that most securities are tick-constrained due to Rule 612. Thus, rather than a one-size-fits-all approach, we assert that potential regulatory reform should instead focus on a subset of securities that are true candidates for a tick-reduction regime. Introducing a one-size-fits-all finer minimum tick increment risks creating a structure that attempts to solve a problem that does not exist for most securities and introduces roadblocks to the liquidity aggregation and price discovery process.
The Danger of The One-Size-Fits-All Approach
Institutional investors play an important role in U.S. capital markets. With the growth in popularity of pooled investment vehicles such as ETPs, Federal Reserve data shows 62% of U.S. public equities are managed by institutional investors. Institutional investors’ participation in these financial markets provide enhanced price discovery, increased liquidity and allocative efficiency. Like all other investors, institutional investors also depend on a level playing field. We believe that a one-size-fits-all application of a tick-reduction regime may risk failing to account for new inefficiencies introduced to institutional investors by an unnecessarily granular tick-size for most stocks.
As an example, we examined Tesla’s (TSLA) order book. Exhibit 2.1 below shows what TSLA’s typical order book during regular trading hours would look like.
Implementing a one-size-fits-all tick-reduction regime would result in an order book that could look more like Exhibit 2.2.
This new order book is highly fragmented in comparison to the one that exists today. As institutional investors trade in substantially larger sizes than the average investor, such fragmentation would make their liquidity aggregation process substantially more difficult. This, in turn, impacts the price discovery process, an important market function.
Proposal: A Nimbler Framework
Thus far, empirical evidence shows that most securities are not currently tick-constrained. In addition, a one-size-fits-all tick-reduction regime could be harmful to market structure. We believe an objective, selective and nimble three-step framework that focuses on securities that are truly tick-constrained would be more appropriate. Our proposed framework is detailed below.
First Step: Designing Objective Criteria
The first principle of the proposed framework selects candidates based on an objective set of criteria. We propose that a security is a candidate for the tick-size-reduction regime if it satisfies the following top-down framework:
1. Constraint: Tight average inside quoted spread
We believe these securities are being quoted at such tight spreads that there are possible benefits to be gained from exploring whether these securities should be quoted in finer increments.
2. Cost: High quote-size-to-trade-size ratio (Quote-Trade Ratio)
The Quote-Trade Ratio calculates the daily average of each security’s inside quote-size-to-trade-size ratio. We consider this criterion an objective signal that shows even though there is an abundance of liquidity, the current $0.01 tick constraint disincentivizes investors to cross the spread due to high costs, resulting in a lack of trade executions.
3. Liquidity: High average daily notional turnover (Notional Turnover Ratio)
The Notional Turnover Ratio calculates the daily average of each security’s notional value traded divided by its daily market capitalization. We believe this criterion is appropriate as an objective signal because it focuses the tick-reduction effort on high turnover securities that would benefit from the ability to be traded in finer increments. Conversely, we do not believe thinly traded securities in proportion to their market capitalization—which would have low notional turnover—should be the focus of a tick-reduction effort.
Second Step: Refining Parameters
For each of the above criteria, it is important to choose objective parameters to select the appropriate candidates for a tick-reduction regime. We determined a statistical approach is most appropriate.
For the quoted spread factor, we believe it is most appropriate to set a parameter of 1.1 cents, selecting securities with an average daily quoted spread at or below 1.1 cents as candidates for a tick-reduction regime.. Within this selection, we see a high concentration of securities being quoted closer to one cent, as shown in Exhibit 4.1. Accordingly, we believe it is evident that these securities exhibit highly tick-constrained characteristics.
Next, we observed the distribution of these securities’ quote-trade ratios to cluster on the left-hand side as shown in Exhibit 4.2 below. We focused on securities on the long right tail of the distribution, those with high Quote-Trade Ratios. Thus, for the Quote-Trade Ratio parameter, we designated the top 75 percentile as an objective threshold (Exhibit 3).
Similarly, our analysis shows most securities with quoted spreads below 1.1 cent concentrated on the left-hand side of the distribution of the Notional Turnover Ratio. The majority of these securities are thinly traded and should not be considered to tick-constrained (Exhibit 4.3). Consequently, for this parameter, we selected the top 75 percentile as the objective threshold for consistency with the selection method for Quote-Trade Ratio (Exhibit 3).
Third Step: A Nimble Approach
Securities pricing and market structure are ever changing. A robust price discovery process is one of the key characteristics of the U.S. equity markets, making them the global gold standard.. As security pricing and trading behavior change, we believe it is important for regulatory action, such as a tick-reduction regime, to be nimble. Thus, we propose that the selected parameters—such as spreads below 1.1 cent and top 75 percentile of ratios—remain fluid. This means the values of the parameters should be periodically reviewed and calibrated on a quarterly or bi-annual basis to reflect changes in market conditions. We believe nimble policies ensure that potential market structure reforms keep pace with changing market conditions and in turn, facilitate continued fair, orderly and efficient markets for the benefit of all investors.
Tick-Reduction Regime in Action
Exhibit 5 above summarizes an objective universe selection framework of a tick-reduction regime. With an objective, selective and nimble framework, the potential universe of true tick-constrained securities is much smaller than previously believed. The objectiveness of this framework enables potential regulatory applications to be much more selective, and focused on actual market inefficiencies and needs, rather than a one-size-fits-all policy, which could potentially be harmful to market structure. Exhibit 6 below shows the cluster of tick-constrained securities based on the objective parameters of Quote-Trade Ratio and Notional Turnover Ratio.
Artificial Spread Reduction: Forward Stock Splits
We examined changes in these securities’ parameters as their spreads are artificially reduced in order to understand the effect of a one-size-fits-all tick-reduction regime on the objectively selected parameters Without a pilot program, we used forward-split corporate actions as a proxy. A corporate action is an event—initiated by the company’s board of directors and agreed upon by its shareholders—that causes material changes to the company’s securities.
When a forward-split corporate action is taken, the company increases the number of outstanding shares while the total notional value of those shares remains unchanged. As a result, the price of the security is artificially reduced, consequently reducing its inside quoted spread.
We examined changes to our objective parameters of 34 NMS securities that were subject to a forward-split between January 3, 2022 and July 23, 2022. The effective date of the forward-split was used as the benchmark date and the event window used for comparison is one month before and one month after the benchmark date. We measured the changes in the parameters by comparing the average of the parameters of the period before the benchmark date to the “after” period. We believe the window length of one-month pre- and post- split provides accurate data to evaluate the impact of such event on market structure.
The result shows the potential negative effects of an artificial spread reduction—a product of a one-size-fits-all tick-reduction regime—has on market structure. As expected, the 34 securities experienced an average reduction in spread of 31 cents (Exhibit 7.1). Assuming the claim that all securities are tick-constrained due to Rule 612 has merit, we would expect the spread-reduction effect brought forth by the forward-splits to result in a positive effect on our proposed tick-constrained benchmarks: a reduction in Quote-Trade Ratios and an increase in Notional Turnover Ratios. However, when comparing these parameters pre-split and post-split, the Quote-Trade Ratio grew more than 10x larger in 17% of the analyzed securities, suggesting that they might have been even more constrained post-split (Exhibit 7.2).
Similarly, we observe an up to 14% decrease in notional turnover, signaling a substantial reduction in liquidity (Exhibit 7.2). Accordingly, empirical evidence does not support the claim that all securities are constrained by the minimum quotation increment limit of Rule 612. It necessitates the importance of a selective and nimble tick-reduction framework to avoid introducing undesirable inefficiencies in market structure.
We believe that our review of an artificial spread-reduction regime as a mechanism of stock-splits shows that drastic one-size-fits-all regulatory actions could have negative impacts on market structure. Therefore, we recommend that potential regulatory amendments seeking to address market inefficiencies be empirically-driven and narrowly-tailored to focus on securities that are truly tick-constrained.
Cboe proposes the following:
1. Design a tick-reduction framework based on objective criteria that targets true tick-constrained securities, for which a more conservative initial tick-reduction to 0.5 cents should be considered, instead of a more drastic reduction to 0.1 cents. The framework should be reevaluated quarterly or bi-annually for the parameters to remain nimble to changing market conditions.
2. Decouple the quoting increments from trading increments. This may enable potential mechanisms, such as retail auctions, to increase trading competition in finer increments, without impacting the broader market.
3. Consistent with Cboe’s prior market structure recommendations, accelerate the addition of odd lot orders to the SIP.
4. Modernize Rule 604, also known as the Limit Order Display Rule, to adjust display block orders from the current thresholds of 10,000 shares and $200,000 notional value to 50,000 shares and $500,000 notional value.
5. Consider a tick-widening framework that facilitates an enhanced liquidity aggregation process for securities trading with wider spreads.
Cboe believes empirically driven and targeted equity market structure reforms are important to maintain fair, competitive, robust and resilient markets that are inclusive of all investors. We are committed to working toward a solution in partnership with our regulators and industry peers and welcome discussion about this proposal.