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Improving Liquidity for Small Cap Stocks

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Picture Credit: OTA Photos || This is easier said than done!

The SEC is seeking ideas on how to make small cap stocks more tradable. Let me quote the closing of an article from the Wall Street Journal:

In soliciting the proposals, the SEC laid out a number of possible approaches, without endorsing any of them.

One such approach would limit trading in low-volume stocks to the exchange where they are listed. Nasdaq Inc. has promoted a similar plan, arguing that it would create deeper markets for small-cap stocks by concentrating the trading of their shares on one venue. But critics, including some rival exchanges, 
have attacked Nasdaq’s plan as anticompetitive, saying it would benefit big exchanges like Nasdaq.

In another approach floated by the SEC, trading in low-volume stocks would take place in periodic auctions, separated by discrete time intervals, instead of continuously throughout the trading day.

SEC Seeks Ideas For Improving Trading in Small-Cap Stocks

I’m not sure that any of these proposals will work. Longtime readers know that I think that liquidity is hard to permanently increase, or decrease for that matter.

By nature, small cap stocks have smaller floats. There’s less information about them Many accounts and managers have mandates that don’t allow them to purchase small cap stocks. Bid-ask sizes and spreads tend to be smaller and larger respectively than those of large caps. That’s largely a function of floating market cap and the underlying riskiness of the company in question. Market structure plays less of a role.

The composition of investors does matter. It typically doesn’t change that much; it is cyclical. Horizons shorten as volatility rises, and vice-versa.

The more buy-and-hold investors there are, the more liquidity decreases. The more traders with short time horizons there are, the more liquidity increases. Commissions declining will possibly make time horizons a little shorter for day-traders, but I can’t imagine that the effect will be that big.

As a smaller investor, I do like the concept of a central order book that would have a monopoly on trading a stock, because it would remove an informational edge that high-frequency traders [HFT] have. I don’t think it would increase liquidity much though. It would change where the trades happen, and perhaps who makes the trades. I think that some less technologically inclined investment advisors would be willing to put up larger bids and asks in such a context, but they would mostly replace lost volume from HFT.

I also think that having more auctions during the day would be a good idea, say like one every half hour. I don’t think it would increase liquidity, though. Trading would become more sparse away from the auctions.

I own four illiquid stocks for my stock strategy clients, and one less liquid closed-end fund for my bond clients. I can trade them if I need to. I just have to be more patient with those securities, and break trades up into bite-size pieces.

For me, trading is a way of implementing changes to the portfolio. If any of the proposed changes happened, my trading would not change much at all. I suspect that would be true for all but the investors with the shortest time horizons, but I think that could go either way. We have lower commissions on one hand, and disadvantages for HFT on the other. Could be a wash.

Enough rambling. I don’t see a lot of likely change here, and liquidity should not be the highest priority at the SEC. Rather than facilitating more secondary trading, it would be nice to see more private firms going public. SEC efforts on that would get my attention.

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