On October 17, 2019, the SEC made a statement inviting stock exchanges and market participants to submit “innovative proposals designed to improve the secondary market structure for exchange listed equity securities that trade in lower volumes, commonly referred to as ‘thinly traded securities.’” On the same day the SEC issued a staff background paper on the subject. The SEC is not asking for input on how a company can better promote its stock and gain investor awareness, but rather how the capital market system, including trading rules and regulations, can be amended or improved to benefit thinly traded securities.
The staff background paper cites many statistics on the number of thinly traded securities, which they define as trading less than 100,000 shares daily. It also refers to the U.S. Department of the Treasury report entitled “A Financial System That Creates Economic Opportunities; Capital Markets” – see HERE for a summary of the report. As a result of this report, the SEC began looking at changes to Regulation NMS and unlisted trading privileges, both of which they continue to review and are now seeking public input on.
The SEC points out that thinly traded securities drive up transaction costs, and can make an exit of security holdings challenging and increase a company’s cost of capital. In its statement the SEC talks about potentially suspending unlisted trading privileges on multiple exchanges for thinly traded securities and overhauling Regulation NMS, including by providing exemptions from the rules. The SEC has raised these ideas previously, HERE).
Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.
Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations, and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
Institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.
Unlisted Trading Privileges
One idea to improve liquidity is to restrict or even terminate unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC-traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.
Market Maker Incentives
In a recent roundtable, a suggestion was made to provide market makers with incentives to trade and make markets in thinly traded securities. Increased incentives to be in, and stay in, the markets for these securities could encourage market makers to quote more frequently and in greater size, which in turn could lead to narrower spreads and increased displayed order interest.
Another possible strategy to help with thinly traded securities is to have periodic intraday auctions as a means of concentrating liquidity in thinly traded securities at times other than solely at the market open and market close. This strategy may assist market participants in finding counterparties for trades, especially larger block trades.
The idea around a non-automated market is that buyers and sellers could negotiate directly and communicate with each other to determine trade prices and order size. To me this seems to result in a sort of private market for thinly traded securities that could result in abuse and an unfair advantage for market participants with knowledge and contacts over Main Street investors.
General Information for Proposals
The SEC statement also includes general instructions and suggestions for submittals. The SEC invites exchanges to proceed with submittals for suspension or termination of unlisted trading privileges under Section 12(f) of the Exchange Act and for exemptive relief from Regulation NMS under current Exchange Act rules. Submittals and suggestions should include an analysis of broader market impacts. Proposals should also cite relevant statutory authority and requirements.
Since “thinly traded securities” is not statutorily defined, proposals should include a definition, whether based on average daily trading volume, number of trades, share volume, or dollar volume, combined with additional factors such as market capitalization, number of shareholders, or public float. Proposals should include an explanation of how the thresholds were set, including any relevant data and analysis and transitioning into and out of the definition. Proposals should include all parameters of a requested rule change, including exemptions, whether companies can opt in or out and the mechanics of implementation.