A major element of the market structure changes the SEC proposed last month (December 2022) involve amendments to Regulation NMS (for National Market System), the comprehensive set of rules governing equities trading in the U.S.1 If enacted, these proposals would represent the first significant set of changes to Regulation NMS since it was adopted in 2005.2 For context, in that same year, George W. Bush started his second term as President, Hurricane Katrina hit New Orleans, and something called “YouTube” was introduced. The iPhone was still two years away from seeing the light of day.
The markets themselves have changed dramatically. In 2005, the New York Stock Exchange was still largely a floor-based market. It dominated corporate listings and also dominated trading in those listed stocks, accounting for 78% of those stocks’ total trading volume. Its speed of execution for small orders was 10 seconds.3 Nasdaq was not yet registered as a national securities exchange. The percent of volume traded by “dark” markets (those that don’t publicly display quotes) was 13% of volume in NYSE stocks and 29% of Nasdaq stock volume.4
Today, there are 16 different equity exchanges, no one of which handles more than approximately 20% of trading volume, and multiple non-exchange “dark” venues that together handle close to half of total volume. The average daily volume for listed stocks in February 2005 was about 3.9 billion shares,5 compared to daily volume of NMS securities last year of about 11.8 billion shares.6 Trading times are often measured in millionths of a second.
Over the next several weeks, IEX will break down each part of these important proposals: changes to minimum quoting and trade increments or “ticks”; changing the cap on exchange access fees and how fee and rebate schedules are set; and creating more transparency for better-priced orders. For each part, we will summarize the relevant rules that exist today, how trading and practices have changed in recent years, what changes the SEC proposed and the reasoning it gave, and some of the issues raised and potential alternatives the Commission laid out.
Today’s post focuses on the changes to tick size.
What Rules Apply Today?
Under SEC Rule 612, market operators and brokers are not allowed to “display, rank, or accept” an order at a price in an increment smaller than one cent, for all NMS (exchange-listed) stocks priced at $1 per share or more. In adopting Rule 612, the SEC explained that it was seeking to prevent traders from “stepping ahead” of other displayed orders with prices that differed by an “economically insignificant amount.” The point was to encourage meaningful price competition rather than “gaming” behavior. The Commission was also concerned that too-narrow quotes would lead to too much “quote flickering,” making displayed quotes less reliable, and also reducing the shares that would be available at the best price. It determined that less depth at the best price could increase transactions costs, especially for institutional investors that tend to place large orders. Overall, the SEC sought to promote market transparency and efficiency by giving incentives for a broad spectrum of people to use automated displayed quotations.7
While Rule 612 limits the tick size for orders, it does not limit prices at which trades can happen. When it adopted Rule 612, the SEC considered but chose not to require that trades occur at the minimum quoting increments. It reasoned that trading in sub-penny increments did not raise the same concerns that sub-penny quoting raised about flickering quotes or reducing the size of displayed orders at the best price. It also allowed traders to continue to price trades at the midpoint of the displayed best bid and offer (BBO) prices, or to rely on a benchmark, such as the volume average weighted price, exceptions to the one cent rule that are often used by institutional traders.8
Apart from the midpoint and benchmark exceptions, the SEC has also provided exceptions that allow exchanges to operate liquidity programs specifically for retail orders, where trades can execute in tenth of a cent increments. IEX operates its own retail liquidity program, which requires that retail investors receive price improvement at the midpoint or better.9
One result of this distinction between orders and trades was to limit how exchanges and alternative trading systems (ATSs) can compete with other participants for orders. Because their business involves orders of various counterparties, exchanges and ATSs are effectively limited to trading at one cent increments for the orders they receive, or at the midpoint. Other markets, including wholesale dealers that execute orders as principal rather than matching orders, accept orders in pennies but can then execute those orders at 100 price points within the one-cent tick.
What Has Changed Since 2005?
First, an exponential increase in quote and trade volume, as noted above. Along with the increase in volume, the spread between the best bid and offer prices has narrowed for many stocks. That change is generally viewed as positive, but it also means that many stocks have become “tick constrained,” meaning that participants would choose to quote many stocks using tighter increments but are prevented by the rule from doing so. For example, the SEC found that stocks with an average quoted spread of 1.1 cents or less (suggesting they are tick-constrained most of the time) now constitute a majority of all share volume.10
Second, as noted, a substantial and continuing increase in off-exchange volume. Along with that comes a corresponding decline in the proportion of trading that results from displayed limit orders, with “dark” trading volume now accounting for a majority of all volume in many stocks. This decline in “lit” trading raises concerns about negative impacts to market efficiency by the erosion of transparency and the price discovery function that displayed trading provides.11
Third, a substantial growth in the proportion of trading that results from retail orders that are “internalized” by securities wholesalers. This corresponds to a large increase in the volume of trades that occur off-exchange at sub-penny prices. The SEC estimated that the internalized segment now represents about 24% of total equity volume. It also found that of all sub-penny trades reported (other than those at the midpoint), 89% in value occurred away from an exchange.12
What Did the SEC Propose and Why?
The Commission proposed replacing the existing one cent standard for stocks priced at $1 or more with four tick sizes, ranging from one-tenth of a cent up to one cent. The SEC is not proposing to change the rules for stocks priced under $1. Securities would be allocated based on their total weighted average quote spread (essentially, the average spread between best bid and offer prices weighted by how long a stock stays a certain spread). The allocation of securities by spread category can be summarized as follows:
The allocation within these categories would be refreshed each calendar quarter, based on a review of trading during the last month of the preceding quarter. Within each of these categories, stocks would also be required to trade in these same increments, whether trading on or off exchange, while keeping exceptions for midpoint and benchmark trades.
The SEC said its review showed that for many stocks, participants would compete to improve the price by a meaningful amount but are prevented from doing so by the existing regulation. As you can see by the table, the Commission proposed creating a variable tick structure not just for stocks with spreads close to the one cent constraint. It also included others with a spread of up to four cents, which it believed could help to prevent those additional stocks from becoming tick-constrained. In effect, the SEC matrix allows for a range of four to eight ticks within a spread category. For instance, by applying the quote/trade increment of $0.002 to stocks with a spread greater than $0.008, but not more than $0.016 cents, participants would at all times have at least four but not more than eight price points within the spread for both quoting and trading.
In estimating the appropriate number of ticks, the SEC relied in part on data from its tick-size pilot conducted from 2016-2018. That experiment tested the effect on market quality when tick sizes for certain less liquid stocks were forced wider than one cent, compared to the effect when the tick size reverted to one cent. At the same time, the Commission acknowledged that there are risks to setting tick sizes that are too narrow, and it sought input on how and where it should draw this line. The SEC estimated that the sub-penny ticks it proposed would currently cover about 81.9% of all trading volume and 60.2% of dollar volume.13
By proposing to apply these same ticks as common trading increments, subject to exceptions, the SEC said it is seeking to promote fair competition and equal regulation among exchanges, ATSs, and wholesale dealers, by addressing the disparity that occurs because off-exchange executions can happen much more freely in sub-penny increments.14
Issues and Alternatives
Many industry observers have long called for some change to the one cent standard for some stocks. Much of the debate is likely to focus not on whether but how to change the rule – especially regarding how narrow and complicated new tick categories should be and how many symbols should be covered by a sub-penny standard. Tick sizes of one-tenth and two-tenths of a cent are narrower than most industry proponents have argued for. One point of debate is whether and to what extent tick sizes at that level of granularity raise similar concerns about complexity, gaming behavior, and flickering quotes that the Commission has considered before.
The SEC asked for feedback on a large number of potential alternatives to its proposal. The following are just a few, which we are highlighting because they represent somewhat simpler alternatives or mirror previous industry proposals.
Two Tick Alternative
This proposal would call for a half-cent tick for “tick-constrained” names, meaning those with an average spread no more than 1.1 cents (using the method to determine spread proposed by the SEC). A variation of this idea would also apply the half-cent tick to “near” tick-constrained stocks with average spreads of up to two cents. All other securities would retain the existing one-cent tick size.
This alternative would respond to concerns about potential unintended consequences of setting tick sizes that are too narrow but would at the same time capture a substantial volume of trading volume. It would, however, beg the question of whether and how to set a minimum trading increment. For example, a trading increment could be set at the same quote increments, with exemptions applied to retail orders, or it could instead be set at a constant increment that would apply to all types of orders. In the case of this and the other alternatives discussed below, the SEC could make use of its general exemption authority to allow approved retail execution systems to trade at narrower, 1/10th of a cent, intervals.
Three Tick Alternative
The SEC could reduce the number of tiers to three: a tick of $0.0025 (for stocks with spreads up to one cent): $0.005 (for spreads of one to two cents): and $0.01 (for spreads greater than two cents). This alternative represents a slightly simplified version of the SEC proposal but results in a smaller number of ticks (2-4) within the spread buckets. Even with that modification, it still goes narrower than most industry proponents have called for. Under this alternative, trade increments could be set at the same ticks, again with exceptions for midpoint and benchmark trades and approved retail programs.
The SEC could both narrow the tick for highly liquid stocks and also widen beyond one cent for, more illiquid securities with larger spreads. This approach is premised on similar concerns about narrowing the tick size too much: the argument is that for symbols with very wide spreads, one cent can represent non-meaningful price improvement and can depreciate the value of displayed orders in those stocks. A 2019 industry proposal adopted this idea, recommending six tick sizes, extending from a half-cent up to 25 cents.15 A simplified version could reduce the number of ticks sizes to three, with a maximum tick size of two cents.
One challenge facing this alternative is how to address the output of the SEC’s 2016 tick size proposal. That long and expensive effort was largely deemed a failure, leading to no clear consensus on the value of widening tick sizes for less liquid stocks.
Instead of basing tick sizes on the average spread, they could be set based on stock price. For example, a smaller tick size could be used for all stocks priced less than $10 per share. That would be simpler to administer and perhaps easier for retail investors to understand, with the trade-off being that it is less accurate in aligning tick size with trading characteristics of individual securities.
Weighing these and other approaches against the SEC proposal involves complicated trade-offs of relative complexity or simplicity, the potential efficiency benefits of closely tailoring tick sizes against concerns about unintended consequences, and other factors.
Closing Thoughts: From Ticks to Caps
If tick size proposals seek to make exchange trading more efficient and competitive, there is a corresponding need to consider the costs of trading on exchanges and to rationalize the system that exchanges use for setting both transaction fees and rebates. The Commission, recognizing the connection, is proposing changes to address those related issues, and that is the topic of our next post. Stay tuned!
 See Securities Exchange Act Release No. 58108, 70 FR 37496 (June 29, 2005) (“Reg NMS Release”).
 See Securities Exchange Act Release No. 96494, 87 FR 80266 (December 29, 2022) (“Proposing Release”).
 Memorandum to SEC Market Structure Advisory Committee from SEC Division of Trading and Markets, dated April 30, 2015., at 7-8, avail. at https://www.sec.gov/spotlight/emsac/memo-rule-611-regulation-nms.pdf(“TM Memo”).
 TM Memo at 12.
 IEX Market Data, NYSE TAQ
 Reg NMS Release, 70 FR at 37550-37551.
 Id. At 37556.
 See IEX, “An Evolved Retail Solution for an Evolved Retail Landscape (May 6, 2021), avail. at https://www.iexexchange.io/blog/an-evolved-retail-solution-for-an-evolved-retail-landscape.
 Proposing Release, 87 FR at 80268.
 See IEX, “Losing Transparency in America’s Stock Markets: How to Bring More Trading into the Light” (November 16, 2021), avail. at https://www.iexexchange.io/blog/losing-transparency-in-americas-stock-markets-how-to-bring-more-trading-into-the-light.
 Proposing Release, 87 FR at 80306, 80273.
 Id. at 80278.
 Id.at 80273.