If Banks Can't Overcharge You For Trading, How Can They Afford To Bring You More Overpriced IPOs?

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A pretty widespread fact of life is that if it costs you $9 to make a widget and you sell it for $10 then you make $1, and if someone else comes along and starts selling widgets for $9.50, then you have to either sell fewer widgets or sell them for less money or both, and this makes you angry, because you were making $1 per widget and now you are making less and that's just not the American way. But it happens, often, and you probably get really mad about it and go do things like lobby Congress to ban foreign widgets or whatever. One thing that probably wouldn't occur to you is to lobby Congress to ban change - as in coins - so that nobody could undercut you by 50 cents. This, it turns out, is because you are not creative.

This thing about bringing back fractions in stock prices is not new but it's rumbling forward and so is Sandy so I guess let's talk about the fractions? Here is the thing:

The push to revert to wider "tick sizes," as traders call them, comes amid an argument over whether or not decimalization has made markets less welcoming for small companies looking to attract investors to their initial public offerings of stock. Some executives, banks and advisers say that banks do less to drum up investor interest in these shares because of lower profits.

As evidence, people in this camp point to the decline in the number of U.S.-listed company IPOs raising less than $50 million. In the late 1990s there were typically more than 100 such IPOs a year, compared with fewer than 10 so far this year, according to Dealogic.

If you move away from penny pricing, "investment banks will be able to make enough money trading ... to write research and re-create the spark in the engine," said Jeffrey Solomon, chief executive of Cowen & Co.

What is the product that you sell when you trade a stock? A naïve answer is "liquidity" or "execution" or what have you. You get paid X cents a share for providing liquidity in those shares. If it costs you 4 cents to provide liquidity and you sell it for 5 cents, then you make a cent. If it costs someone else - probably an HFT robot - 2 cents to provide liquidity and it sells it for 3 cents, it makes a cent, and you make nothing.

That's fine; I posit that the market for stock market liquidity is to some approximation a pretty efficient market. Like, it's got computers and continuous quotation and stuff, don't kid yourself, it's better than the market for cars or medical residencies or whatever. Prices more or less balance supply and demand.

Except that the product that you sell when you sell stock trading liquidity is not really stock trading liquidity, or at least not the instantaneous moment of liquidity represented by that particular trade, or at least you can say it's not. It's also your broader contributions to liquidity: the research you provide on the stock that you're trading that makes people aware of it generally, the sales effort that makes people want to buy it today, the IPO that you underwrote that makes it possible to buy it.

All of those things cost money and the first two don't pay - they're subsidized by the price you charge for immediate liquidity.1 Your five cents a share pays for two cents of actual trading costs, one cent of research, one cent of incentivizing you to do more IPOs, and one cent of profit. And if some HFT robot can come in and charge only the two cents of actual trading costs then there go your IPO incentives. Coincidentally today also brings this amusing post from the NY Fed's Liberty Street blog about weakness in the US IPO market. It's hard to disentangle cause and effect here but here are IPO volumes:

So, fewer and larger IPOs since the 2000-2001 move to decimal pricing. Maybe that's cause and effect? Or maybe IPO companies just got crappier:

What does it mean? Who knows; it is not obvious a priori that private companies should have been crappier in the 2000s than in the 1990s which suggests that the quality gap is not about "companies" but rather "IPO companies," i.e. the relative attractiveness of IPOs. So perhaps the decimalization theory is right.2

Probably it is? I have no real well-formed view. But isn't the conversation weird? Lots of industries survive on bundling - hi, cable! - but where else would you overcharge for a commodity service (stock trading) with no barriers to entry that anyone can easily provide, in order to pay for a premium service (research, small-cap IPOs) that you give away or underprice? And then get a regulator to protect your margins on the commodity service by regulating, of all things, price increments?

Some other places, probably, but this does seem like an impressive achievement of the financial industry. Here's John Kay:

Much complexity has been deliberately created, to encourage consumers to pay more than they need, or expected. ... Artificially manufactured tariff complexity is endemic in the utility and financial services sectors. Yet these are sectors with particularly active and intrusive regulators. The paradox is that regulation has not only failed to relieve the problem but may actually have made it worse.

He's talking about something totally different but that seems applicable here, no? The financial industry is a weird mess of cross-subsidization protected by client confusion and regulatory benevolence. Basically nobody pays cost-plus-markup for the financial services that they buy; they pay some price determined by tradition and negotiating ability and expectations of future business, and then they get cross-sold on other things, and it mostly works out, more or less. This means that if you're a smart and aggressive client you get really cheap service - think of all the investment grade companies that get underpriced credit facilities as banks try to win their capital markets business, or the companies that have bankers on call for years doing all of their financial modeling in the hopes of one day winning M&A business - without ever paying for it in the form of overpriced premium stuff. And if you're less attentive and aggressive you, ummm, buy a lot of exotic derivatives?

This system can be nervous-making for bankers - if your pricing is built on hope and tradition it's easy to get it wrong - but it's hard to imagine it doesn't lead to higher profits on average; otherwise why do it? The guys who won't underwrite teeny IPOs until they can charge more for aftermarket trading didn't create this world; they just live in it, and maybe they're right that a little bit more cross-subsidy will improve the IPO market. But it'll definitely improve their own profits.

SEC Weighs Bringing Back Fractions in Stock Prices [WSJ]
Weakness in the U.S. IPO Market [NY Fed]
The wrong sort of competition in energy [John Kay via Farnam Street]

1.The last one - the IPO - actually pays quite well thank you! But I guess not well enough? A $40 million IPO should be a $2.8mm ticket to the underwriters at 7%, but probably doesn't cost them appreciably less than, say, the $100mm-ticket Facebook IPO. Lawyer bills, roadshow jet charters, etc. don't scale down for small deals.

2.The Fed says "One explanation for the weakened financial condition of IPO issuers over this period is the strategic decision of profitable private firms to merge with public firms in a similar industry that can introduce their products to the market more quickly"; I dunno. Strategic or financial?)

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