Can capital markets — and the middle class — be saved by the quarter dollar?
As a follow-up to my previous post regarding dark pools and hedge fund regulation, I happened upon a blog post on how to save the financial skin of the middle class from Scott Kupor, a managing partner at the famed Andreessen Horowitz venture capital firm in the Y Combinator Hacker News (which I highly recommend – check out the hack to use your browser window as a notepad).
Mr. Kupor’s plan for saving the middle class is genius. Bring back the quarter dollar!
In 2001, the SEC switched the tick system for exchanges from fractional increments to decimal increments, leading to more liquid markets, particularly for large capitalization securities. Smaller market securities have not fared so well, and one reason proffered by pundits is that diminished spreads in lightly traded securities eliminated any incentive for market makers to trade these stocks.
As a corollary, the 2003 ban on subsidizing analyst research with investment banking revenue wiped out the primary source of funds for small-company reports, which further decimated the market for smaller company securities.
How does Mr. Kupor believe this important but relatively arcane set of rule changes hobble the US middle class? Because the number of US market IPOs has fallen by two thirds since the 1990s (the number of smaller IPOs shrinking by 80 percent), with the average length of time a company will fund itself privately before going public doubling (from just under 5 years to 9.4 years). When companies do go public, they tend to price much higher than used to be the case (Facebook going public to a $100 billion market value compares to Microsoft going public with a $500 million market value), taking much of the potential return for ordinary investors off the table.
Mr. Kupor (and, to be fair, many other thoughtful industry players, as well) believe restoration of the 25-cent tick would juice the IPO market by once more creating a profitable climate for supporting an investment ecosystem for smaller public companies. Advantages to middle-class America extend beyond access to more profitable investing opportunities in the public markets. Mr. Kupor calls attention to studies spotlighting the importance of IPOs for job creation, both directly through capital raised for growth and indirectly through the significant multiplier effect of technology jobs.
In the past year, the SEC has fulfilled JOBS Act research and regulatory mandates concerning the decimalization dilemma by issuing a report to Congress and sponsoring a roundtable on decimalization (Knowledge Mosaic offers a vast amount of information on decimalization dating back before 2000, including agency materials and law firm memos). In its report to Congress, the SEC walks back the argument for restoring the 25-cent tick by citing countervailing data on the impact of decimalization – suggesting that tick spreads and market liquidity for smaller companies has not suffered and that other factors related to market globalization and greater access to private financing may better explain the collapse of the IPO market.
I am riding no horse in this race, but can offer several observations about the horses and jockeys, as well as the surface conditions of the track.
First, Mr. Kupor frames his specific argument about decimalization with a vague screed about how U.S. government regulators with their byzantine regulations have deprived working Americans of access to the fruits of American business innovation for the next 50 years. Mr. Kupor never returns to this broader theme (and in fact praises the JOBS act as a positive legislative achievement), but the effect is nonetheless to lace the remainder of his post with its implicit poison. In so doing, Mr. Kupor sidesteps the business and policy context for both decimalization and the research ban related to the excesses of the Dotcom bubble (when anyone taking a class in HTML could become the CTO of a venture-funded company and banker analysts such as Henry Blodgett never met a public company they didn’t like). When adopted in 2001, the benefits of decimalization (global competitiveness of US markets, cost relief for the smaller investor, and a more level playing field with large investors, given their access to smaller trading increments than offered in the public markets) seemed self-evident. By strengthening markets that had cratered terribly, decimalization arguably also hastened the recovery of those markets.
Second, Mr. Kupor neglects to mention that venture funds, which have struggled mightily in recent years, stand to benefit from a revitalized IPO market far more directly than would a vaguely defined middle class. It is true that very large IPOs such as Facebook reap huge rewards for their venture sponsors compared to smaller IPOs. However, it is even more true that total IPO dollar volume has shriveled from an average of $70 billion between 1996 and 2000 to an average of only $28 billion between 2008 and 2012.
Even with these caveats, however, it seems clear that the decimalization debate is in many ways an argument between investors and traders, and it is one that investors are not winning in the court of regulatory opinion. Vastly lower spreads favor high-speed traders by minimizing the friction created by transaction costs. Lower spreads do not enormously benefit long-term investors. Additionally, while traders don’t particularly need or care about a healthy ecosystem for sustaining smaller companies in public markets, there is little doubt the U.S. economy and ordinary investors do benefit from and need this ecosystem. For these reasons, the SEC’s unwillingness to commit itself to restoring a nurturing, sustaining environment for smaller public companies is the other side of the agency’s inability to rein in dark pools and high-speed trading systems that nurture and sustain hedge funds.