SEC weighs wider spreads for small-cap trades

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In the face of heavy lobbying, the U.S. Securities and Exchange Commission is revisiting the argument to widen tiny trading spreads for small-cap stocks.

On Tuesday, the SEC will host a session where more than a dozen market participants and experts will debate whether the U.S. should increase trading spreads for small companies.

For those advocating a change, the thinking goes like this: before 2001, all stocks traded with spreads – the difference between bid and ask price – that were fractions. If a market maker matched a buyer and a seller, he or she made a minimum of 1/8 of a dollar on each share for facilitating the deal. Back in the day this was a very lucrative business, and the SEC ultimately found that the wide spreads created "excessive profits."

Spreads have all but disappeared since the turn of the century. Eventually, 1/8 turned into 1/16, then 1/32, and then fractions were replaced by "decimalization." Today most stocks trade with spreads of just one cent, meaning the market makers don't make much money.

Those who argue for wider spreads for small companies argue that if brokers could make more money trading them, these stocks would become more liquid, and that would convince more companies to go public. (No one wants to launch an IPO and then have their shares rarely change hands.)

The odd thing about Tuesday's hearing is that the SEC already studied the issue and ruled in favour of the status quo. As part of the JOBS Act passed in 2011, the regulator conducted a detailed analysis and put out a formal ruling last July that said there is no need for a change.

"Although mandating an increase in tick sizes [spreads] to levels greater than those that are presently dictated by market forces may provide more incentives to market makers in certain stocks, the full impact of such a change, including whether or not an increased tick size would indeed result in more IPOs, and whether there would be other significant negative or unintended consequences, is difficult to ascertain," the SEC ruled.

The regulator added that there are simply too many variables that affect whether a company will go public or not to definitively say wider spreads would matter.

But the groups arguing for change didn't let that report stop them, and now the debate will get public air time. Tuesday's speakers include David Weild, the former vice-chairman of Nasdaq and now head of capital markets at accounting firm Grant Thornton, as well as the University of Toronto's Kent Womack.

At this point there's no sense of whether this is simply the SEC's way of attempting to let the proponents say their peace, or if this will re-open the debate despite last summer's ruling. But it's pretty obvious that traditional brokers will fight tooth and nail for higher spreads, because their old equities businesses have all but dried up.

(Tim Kiladze is a Globe and Mail Capital Markets Reporter.)