Bloomberg TV: Understanding Why Decimalization in the U.S. Disproportionately Hurts Small Cap Stocks

imagesDecimalization, quoting stock prices in decimals instead of fractions, isn’t a problem in and of itself.  The problem results from turning a market spread that used to be $0.25, for example, into 25 1-penny increments because it takes the positive economics out of trading that stock for market makers who are supporting relatively unknown emerging growth  small cap companies.  Why does this matter?  Because if you can’t make money risking your capital by providing liquidity for others, you won’t.  This change to decimalization occurred in 2001. Combined with New Order Handling rules originally passed in September 1996 and implemented in 1997, these modifications to technical trading rules fundamentally changed how then-emerging electronic trading networks (ECN’s), such as Instinet, could buy and and sell stocks. In short, ECN’s could transact within the market maker’s spread and force the market maker to execute at the ECN’s order price.  The problem with this, again, is that it caused market makers to lose money, so they stopped marking markets in stocks where they would lose money.  Simple enough, but the unintended consequences of well-intended regulations have had the severely negative impact on our economy of gutting liquidity and research support for small cap stocks.  As a result, small companies that are otherwise worthy of going public cannot access the public markets because they cannot support a large enough underwriting to attract large cap investors.  This is why the underwriting criteria for IPOs today require companies to have $100mm plus in revenues, have a multi-year history of positive cashflow generation, and be profitable on a GAAP basis, at a minimum, in order to raise sufficient capital to generate sufficient after-market liquidity for underwriters to take on the new listing.  The losers are the next generation of innovative companies and the entrepreneurs who lead them– today’s version of Intel, Dell, EA, Applied Materials, Symantec, Oracle, and many other well-known companies who could not meet today’s IPO criteria but did successfully go public and grow into industry giants through IPO’s completed before 1997. Watch this Bloomberg TV video, featuring David Weild, which tells the story. CLICK HERE FOR VIDEO LINK

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