April 23, 2018

Securities and Exchange Commission Division of Trading and Markets Roundtable on Market Structure for Thinly-Traded Securities

Key Topics & Takeaways

Panel One—Challenges in Market Structure Performance of Thinly-Traded Exchange-Listed Equity Securities
- The SEC must first focus on isolating the issue; then the SEC should take a data-driven approach to ensure the best outcome for thinly traded securities.
- The illiquidity of these thinly traded securities negatively impacts their access capital.
- The best solution may not necessarily have SEC rules to concentrate liquidity but rather foster exchange innovation to aid the thinly traded securities market.
- A panelist recommend the SEC update its market-making rules to reflect current economic realities.
Panel Two—Potential Improvements in Market Structure of Thinly-Traded Exchange-Listed Equity Securities
- The panelists generally support creating different market structures based on securities’ different liquidity profiles.
- Any potential change should foster an environment of innovation and promote competition, and the SEC should recognize that the off-exchange market provides many benefits that should not be lost.
- Several panelists urged the SEC to review, and potentially revoke or amend, Reg. NMS to encourage the liquidity in this market.
- Several panelists expressed the importance of issuer choice based if they are provided with the appropriate data to make an informed decision.
Panel Three—Market Structure Performance and Potential Improvements for Thinly-Traded Exchange-Traded Products (ETPs)
- Issuers should have the ability to set creation and redemption unit sizes.
- The SEC should review the compensation of market makers to ensure appropriate economic incentives but direct payments may not be the best model.

Opening Statements

SEC Trading and Markets Division Director Brett Redfearn

In his opening statement, Redfearn queried whether the current market structure is appropriate for thinly-traded common stocks and Exchange Traded Products (ETPs). Redfearn stated that securities that trade less frequently have wider spreads and less displayed liquidity, and the current market structure does not fit, particularly for institutional investors who trade in large sizes. Redfearn referenced the U.S. Treasury Report on Capital Markets and requests the panelists to opine on the Treasury’s recommendation to potentially allow issuers of less liquid stocks to partially or fully suspend Unlisted Trading Privileges (UTP) for their securities.

SEC Staff Alex Jadin

Jadin then presented the Division of Trading and Markets Data Paper on liquidity demographics and market quality for thinly-traded stocks. The paper provides a snapshot of the trading characteristics of stocks during the fourth quarter of 2017. The analysis looked a common stocks, ETPs and other products in the NMS space and measured each symbol by average trades per day (ADV) and placed them into the following buckets: (1) ADV less than or equal to 50,000; (2) 50,000-100,000; and greater than 100,000. The data shows that half of all tickers have ADV of less than 100,000, which represents 2% of all trades. The data also shows a higher portion of thinly-traded securities trading off-exchange and as block trades than more liquid securities. As demonstrated by Table 10, the quoted spreads are wider for thinly-traded securities and are more pronounced in common stocks than ETPs.

Panel One—Challenges in Market Structure Performance of Thinly-Traded Exchange-Listed Equity Securities

Each panelist gave their personal background and provided an overview of their firm’s role in the market ecosystem and then answered Redfearn’s questions that facilitated the discussion. The panel participating in this portion of the meeting consisted of:

Steve Cavoli, Senior Vice President, Virtu Financial
Adam Epstein, Founder, Third Creek Advisors
Brian Fagen, Head of Execution Strategy, Deutsche Bank
Bryan Harkins, Executive Vice President and Head of U.S. Markets, CboeBZX
Frank Hatheway, Chief Economist, Nasdaq OML Group
Ovi Montemayor, Managing Director, Financial Markets Services, TD Ameritrade
Ari Rubenstein, CEO, GTS Securities LLC
Jason Vedder, Director of Global Trading and Operations, Driehaus Capital Management LLC

While the panelists recognized the benefits of the current market structure, they highlighted several market changes led to the poor performance of these thinly-traded securities. Harkins highlighted that changes in the liquidity providers, investing strategies and the lack of exchange innovation obstructed market growth for these thinly-traded securities. Hatheway agreed with the difficulties in exchanges to innovate as any new exchange proposal will quickly be mimicked by the other exchanges.

Epstein, based on conversations with executives of these thinly traded companies, stated that this illiquidity also negatively impacts their access to capital. A company stock trading infrequently harms its ability to hire and retain employees, negotiate with vendors, and garner investor interest. Epstein stated that before the financial crisis, hedge fund managers focused more on the fundamentals of the company but now their primary concern with thinly-traded securities is how many days it would take to liquidate their position. Additionally, thinly-traded securities will have no research on the company and are not viewed as potential acquisition targets. Hatheway stated that listed companies typically spend more time addressing investors concerns with their ability to get in and out of the stock rather than telling the company’s story.

While retail investors do not consider liquidity, investing in these thinly-traded securities raise issues for institutional investors. Fagen stated that due to the lack of demand, many times the bank may shift its client’s risk by taking on the illiquid position, which it may have to hold for an extended period of time until it can find a counter-party. Vedder and Fagen highlighted the difficulties of getting in a desired position with the thinly-traded securities, but the real difficulties come when an investor tries to liquidate the position as the investor typically cannot be as patient. Due to the illiquidity, Vedder stated that portfolio managers typically avoid these thinly-traded securities.

Fagen highlighted that the exacerbated information cost of thinly traded securities from the trade-off of revealing information about an order to get liquidity. Vedder agreed by describing the instantaneous impact from posting a quote, which results in bigger swings than highly liquid securities. As a result, Vedder stated that he tries to control this information leakage by completing the initial 20% or more of the order off exchange. Then Vedder described his trading strategy as a “cat and mouse” game of moving from venue to venue, using algorithms, to find the few potential counter-parties.

Vedder stated that consolidating liquidity for thinly traded securities on a few venues would make the trading more efficient and reduce the risk of information leakage. Hatheway agrees with consolidating liquidity and discussed Nasdaq’s imminent rule filing that will allow thinly-traded companies to elect to suspend UTP for non-listing exchanges. Harkins stated that revoking UTP could facilitate counterparties meeting but thinks a better method is foster an environment for exchanges to innovate, potentially by reviewing Reg. NMS. Montemayor opposes consolidating trading of thinly traded securities on a single exchange because trading venue competition provides cost reduction benefits. Rubenstein stated that allowing ATSs to continue to trade, with no UTP for exchanges, will still result in fragmentation and price leakage.

Rubenstein, and other panelists, discussed the important role that dealers serve in providing liquidity to these thinly-traded securities and supports efforts to ensure the rules reflect the realities of today’s capital markets. Most panelists agreed that the reputational knowledge of dealers that went away with Reg. NMS harmed the market for thinly-traded securities. Vedder further stated that knowing the primary dealer for a thinly-traded security would allow him to be transparent with his order by calling the dealer to foster liquidity. The panelists generally agreed that market-making rules should be updated to reflect electronic markets and support publicizing the dealers that display the best price to allow for bilateral negotiations.

The panelists generally agreed that something needs to be done to help these thinly-traded securities and a one size fits all market is likely not the best method. The panelists generally agreed that exchanges need to be able to innovate to aid the securities and that Reg. NMS limits this innovation. Harkins recommended that the SEC consider revoking or amending Reg. NMS to promote innovation. Cavoli stated that before the SEC makes any market structure changes, the SEC must ensure the issue with these thinly traded securities results from counterparties having difficulty in meeting due to fragmentation rather than a mere lack of underlying interest in the securities.

Panel Two—Potential Improvements in Market Structure for Thinly-Traded Exchange-Listed Equity Securities

Tal Cohen, Senior Vice President, North American Equities, Nasdaq
Chris Concannon, President and Chief Operating Officer, CboeBZX
Stacey Cunningham, Chief Operating Officer, NYSE Group
Brian Frambes, Co-Head Global Cash Trading, Fidelity Management & Research Co.
Brad Katsuyama, CEO, IEX Group Inc.
Joe Mecane, Head of Execution Services, Citadel Securities
Robert A. Schwartz, Professor of Finance, Baruch College, The City University of New York
Owain Self, Global Head of Execution Services, Millennium Management LLC

The panelists generally agreed that the SEC needs to create a flexible solution, while balancing the interests of investors and intermediaries, to make the public markets attractive for these thinly traded securities by moving away from the one size fits all regime. Cunningham stated that dealing with these thinly-traded securities is not a new phenomenon as these securities have always been difficult to trade. Self stated that while these thinly-traded securities have been a neglected part of the market, the SEC should not create rules that result in a false sense of liquidity. Prior to making any market structure changes, Mecane stated the SEC should first define the issue and next steps to increase liquidity, give the statistical reasoning for its solution, and then address the problem by amending or creating a rule.

Cohen further elaborated on the benefits of Nasdaq’s upcoming proposal to allow issuers to elect to revoke UTP, but other participants raised potential unintended consequences with this proposal. Concannon stated that exchanges with exclusive listings will likely concurrently increase market data costs because the data will be more valuable as people have to come to that venue for the securities. Self and Katsuyama agreed that when exchanges don’t have to compete for order flow, that exchange can exert market power by increasing fees with no consequences. While Cohen promised Nasdaq would not increase market data prices, others noted it would be difficult and time-consuming for the SEC to restrict price setting. Mecane further opposed revoking UTP for thinly-traded securities, which solves venue fragmentation, because no one has shown evidence that willing participants on both sides of the trade are unable to meet and transact due to venue fragmentation.

In discussing the theme of centralizing liquidity, the panelists also discussed whether to include the off-exchange venues when revoking UTP. While Cunningham agreed with the theme of centralizing liquidity, she stated that any attempt to centralize liquidity will have to include the OTC market. Concannon further stated that evoking UTP will award the listing exchange without benefiting investors because there will still be fragmentation in the OTC market. However, Frambes, while understanding the arguments for including the OTC to truly consolidate liquidity, stressed the importance of off-exchange trading to help investors find natural liquidity and control information leakage.

Rather than revoking UTP, Concannon recommended the SEC consider amending Reg. NMS to create different market tiers and structures to incentivize exchanges to innovate and increase liquidity for thinly-traded securities. Self agreed that the SEC should reconsider Reg. NMS to promote exchange innovation, which does not happen now as exchanges are currently incentivized to avoid costs rather than bringing something new to the market. Frambes expressed his support of a holistic review and potential revision to all aspects of Reg. NMS for thinly-traded securities. Frambes also stated that there would be more contribution to price discovery if there was some order time priority requirement.

Schwartz recommended more call auctions to enhance price formation and bring additional liquidity to the thinly-traded securities market, but other panelists do not see a market demand for more auctions. Schwartz stated that volatility decreases in the first moments before and after the open and closing auctions and more auctions will improve liquidity by pulling orders together. Cunningham would consider auctions for thinly-traded securities, but argued this option becomes less valuable when applied inconsistently and other markets are trading continuously, noting thatNYSE had plans to introduce auctions for thinly-traded securities throughout the day but found there would be no interest in auctions when continuous trading occurs on other venues. Concannon also agreed with the potential benefits of auctions but stated this is not a new solution as venues already can conduct exclusive auctions.

The panelists also discussed the potential benefits of increasing the economic benefits provided to market makers of thinly-traded securities but warned of the dangers that this may create a false sense of liquidity. Concannon recommended the SEC look into allowing issuers to assign a broker-dealer to their security to promote liquidity. Cunningham stated that NYSE imposes the most stringent obligations on market-makers and is a compelling benefit to issuers. However, Cunningham stated that increasing market-making activities will not magically improve natural liquidity. Mecane warned that if the illiquidity is an investment problem, as opposed to a market structure problem, incentivizing market-makers through payments to provide liquidity creates a false sense of liquidity.

The panelists also have differing views on the use of pilots. Katsuyama expressed his support for a pilot programs to gather the data to determine how to proceed with the best plan. However, Cunningham recommends trial programs rather than pilots, which forces issuers into different buckets.

Panel Three—Market Structure Performance and Potential Improvements for Thinly-Traded Exchange-Traded Products (ETPs)

Josh Kulkin, Head of Trading, Jane Street Capital LLC

The panelists expressed the importance of including ETPs in the broader market structure conversations and highlighted that ETPs have different trading characteristics from corporates. Several panelists stated that the ETF market is healthy, well-functioning and has one of the best structures.

Due to the unique characteristics of ETPs, the panelists stated that ETP illiquidity should be measured by the underlying cost of hedging rather than ADV. Thomas stated that while ADV is an appropriate measurement for corporates, who typically have one or very few offerings, ADV does not make sense for ETPs which have daily redemptions and creations and sees the number of outstanding shares change daily. Additionally, Mackintosh stated that more retail firms are investing in ETFs and holding for longer periods, which decreases the turnover. LaValle stated that the SEC should focus on the trading profile and characteristics of the ETP in addition to the demand. Thomas stated that the real measure of liquidity is the redemption and creation costs, which Kulkin and Mackintosh stated could be measured by the cost of hedging the underlying basket of securities. Sutton described a product that Citi offers to help calculate the cost of the underlying securities.

Sutton, in general agreement, stated that ETPs are never too illiquid but some will require a larger spread. Thomas stated that ETFs are not illiquid because the products are tied to benchmarks that can be broken up. LaValle stated that quoted spreads are for the worst-case scenario, and market-makers will decrease spreads when there is more price transparency. Kulkin stated that Jane Street gives wider spreads than the underlying basket when there are difficulties in getting the underlying securities.

The panelists discussed the important role of market-makers for ETPs and ways to align economic incentives. Venkataraman stated that market-maker participation seems to be correlated with ADV and market conditions but this could be solved by imposing affirmative obligations on market makers. Morrison sees a difference in trading when ETFs launch with or without a designated market maker. Venkataraman supports ETPs being able to pay market makers as an investment into the ETPs value just as corporate executives invest in projects to improve the company’s value. LaValle stated that ETP issuers paying market makers will decrease spreads but will also increase the funds’ management fees. Thomas stated that he does not principally agree with paying market makers because it would be better to have clean bid-ask spreads rather than changing the spreads by providing additional payments. Kulkin stated that, as a market-maker, Jane Street wants to be recognized as a leading liquidity provider for giving the best bid-ask spreads rather than a willingness to accept payments.

The panelists generally agreed that the optimal solution for thinly-traded ETPs is allowing issuers to choose the creation and redemption unit sizes. Kulkin stated that the SEC can help thinly-traded ETPs, by giving issuers more flexibility on the creation and redemption unit sizes similar to the John Hancock no-action letter. LaValle further stated that providing more flexibility in creation and redemption sizes will allow the portfolio managers to manage liquidity and as a result spreads will tighten.

For more information on this meeting, please click here.