# Division of Trading and Markets: Background Paper on the Market Structure for

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Division of Trading and Markets: Background Paper on the Market Structure for
Thinly Traded Securities
I. Introduction
The staff in the Division of Trading and Markets of the Securities and Exchange
Commission is issuing this background paper1 in relation to the Commission Statement on
Market Structure Innovation for Thinly Traded Securities to provide information regarding the
trading challenges and characteristics of those national market system (“NMS”) stocks that trade
in lower volume (“thinly traded securities”).2 We summarize a variety of materials regarding
secondary market trading of thinly traded securities, including a 2018 market analysis by the
Division of Trading and Markets’ Office of Analytics and Research (“OAR”) and the U.S.
Department of the Treasury’s 2017 report on the regulation of the U.S. capital markets (“Capital
Markets Report”).3 In addition, we discuss the Commission staff Roundtable on Market
Structure for Thinly-Traded Securities (“Roundtable”),4 where the dialogue among market
participants and the comments submitted centered on the unique trading characteristics of thinly
traded securities. Finally, we discuss the current regulatory framework for thinly traded
securities.
II. Trading Characteristics of Secondary Market Trading for Thinly Traded Securities
A. SEC Staff Study
The data in a recent study prepared by OAR5 indicated that approximately one-half of all
NMS stocks have an average daily trading volume (“ADV”) of less than 100,000 shares and
constitute less than two percent of all daily share volume.

1

This background paper represents the views of staff of the Division of Trading and Markets. It is not a
rule, regulation, or statement of the Commission. Furthermore, the Commission has neither approved nor
disapproved its content. This background paper, like all staff statements, has no legal force or effect: it
does not alter or amend applicable law, and it creates no new or additional obligations for any person.

2

See Securities and Exchange Commission Statement on Market Structure Innovation for Thinly Traded
Securities, Securities Exchange Act Release No. 87327 (October 17, 2019), available at
https://www.sec.gov/rules/policy/2019/34-87327.pdf (the “Commission Statement”).

3

See Division of Trading and Markets Data Paper: Empirical Analysis of Liquidity Demographics and
Market Quality, April 10, 2018, available at
https://www.sec.gov/files/thinly_traded_eqs_data_summary.pdf (summarizing the quoting and trading
characteristics of NMS stocks on the lower end of the liquidity spectrum) (“OAR Study”); A Financial
System That Creates Economic Opportunities: Capital Markets, October 2017, at 59-60, available at
https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-MarketsFINAL-FINAL.pdf (“Capital Markets Report”).

4

See Equity Market Structure Roundtables: Roundtable on Market Structure for Thinly-Traded Securities,
April 23, 2018, available at https://www.sec.gov/spotlight/equity-market-structure-roundtables (providing
press release, agenda, transcript, comment letters, and other Roundtable materials).

5

See OAR Study, supra note 3.

1

Focusing solely on corporate common stocks listed on U.S. exchanges during the fourth
quarter of 2017 (“subject period”), the OAR Study found that of 4,656 corporate stocks, 1,301 of
such stocks had an average daily share volume of less than 100,000 shares. While these
corporate stocks represent approximately 28 percent of all corporate stocks and approximately 15
percent of all NMS stocks, they accounted for only 0.7 percent (i.e., less than one percent) of
NMS stock ADV during the subject period. In addition, while the median trades per day for all
corporate stocks totaled approximately 2,000 trades, the median for corporate stocks that trade in
greater volume was more than 3,600 trades, but was approximately 100 trades for corporate
stocks with an ADV below 50,000 and approximately 500 trades for corporate stocks with an
ADV between 50,000 and 100,000.
The OAR Study found that stocks with lower ADV exhibit different trading
characteristics compared to stocks with higher ADV. First, the OAR Study noted that a higher
proportion of volume in stocks with an ADV of less than 100,000 shares was traded offexchange than the proportion of volume in stocks with an ADV of more than 100,000 shares.6
With respect to trading occurring on-exchange, a slightly higher proportion of share volume of
stocks with an ADV of less than 100,000 shares occurred on the listing exchange, relative to
non-listing exchanges. Second, these securities had a smaller percentage of block trades than
securities trading in greater volume.7 Third, the OAR Study found that these securities had, on
average, fewer exchanges quoting at the national best bid (“NBB”) or national best offer
(“NBO”) than more actively traded securities. Additionally, these securities had a greater
proportion of regular trading hours with only one exchange quoting at both the NBB and NBO or
at either the NBB or NBO than more actively traded securities did. More volume executing offexchange indicates that, relative to actively traded securities, investors view exchanges as less
appealing venues on which to transact. Relatively more trading on the listing exchange may
indicate that market makers on non-listing exchanges do not find it as profitable to make markets
in these securities, causing trading to concentrate to a greater degree on the listing exchange.
Additionally, if market makers on non-listing exchanges do not find it as profitable to make
markets in such securities and thus are less active in these securities, then these securities will
have, on average, fewer exchanges quoting at the national best bid or offer (“NBBO”). For these
reasons, the staff believes that these securities likely face a trading environment with less market
making activity at the inside (i.e., the highest bid and lowest offer) or in larger order size, which
may make finding a counterparty to execute a particular trade more difficult. Finally, quoted
depths at the inside (i.e., the volume of shares available at the highest bid and lowest offer) were
smaller and quoted spreads (i.e., the difference between bid and offer prices) and relative quoted
spreads were greater for securities with an ADV under 100,000 shares than for more actively

6

More specifically, the average percentage of share volume executed off-exchange for each of the less liquid
groups is greater than the average percentage of share volume executed off-exchange for the more liquid
group, for both corporate stocks and exchange traded products (“ETPs”). This finding was more
pronounced for ETPs than for corporate stocks.

7

The OAR Study found, for corporate stocks with an ADV greater than 100,000 shares, that the median
percentage of daily volume traded in blocks was 8 percent, while the median was 1 percent for corporate
stocks with an ADV less than 50,000 shares, and 3 percent for corporate stocks with an ADV between
50,000 and 100,000 shares.

2

traded securities.8 This lack of depth suggests that it will likely be more expensive for an
investor to transact in larger size in these securities.
B. Treasury Capital Markets Report
In October 2017, the U.S. Department of the Treasury issued the Capital Markets
Report.9 The Capital Markets Report set forth a number of recommendations aimed at
promoting economic growth and strong financial markets as well as, among other things,
maintaining strong investor protection. A key category of the Capital Markets Report’s
recommendations addressed how to foster robust secondary markets in equity and debt.10 These
secondary markets, the Capital Markets Report noted, are critical to capital formation and,
consequently, economic growth.11 Therefore, the Capital Markets Report explained,
developments in the markets require regulators to keep pace so that markets can function
optimally for issuers and investors regardless of their size.12
The Capital Markets Report concluded that the current “one-size-fits-all” structure of the
equity markets is not operating effectively for smaller companies that experience lower levels of
liquidity today.13 The robust market depth and breadth that are measures of good liquidity allow
companies to more easily raise capital and investors to realize returns, the Capital Markets
Report stated.14 But liquidity requires a large pool of investors who want to buy and sell
securities, as well as venues that allow them to interact.15 What has emerged, the Capital
Markets Report noted, is that although the largest and most actively traded companies benefit
from the variety of trading venues available to them, the least liquid companies experience less
effective liquidity provision because of that same fragmentation across the large number of

8

See OAR Study, supra note 3, at 7. OAR also made this point during the Roundtable, discussed below.
See Transcript for Roundtable, April 23, 2018, available at https://www.sec.gov/spotlight/equity-marketstructure-roundtables/thinly-traded-securities-rountable-042318-transcript.txt (“Transcript”), at 14
(discussing one example of spreads, both quoted and relative quoted, being wider for the more thinly traded
stocks is that the median quoted spread for common stocks in the lowest tier was 21 cents, and only 4 cents
in the upper tier).

9

See Capital Markets Report, supra note 3.

10

See id. at 6.

11

Id. at 7.

12

Id.

13

Id. The Capital Markets Report characterizes “liquidity” as relating to the “ease, speed, and cost with
which investors can buy or sell assets.” Id. at 56.

14

Id. at 57.

15

Id.

3

equity exchanges and alternative trading systems.16 For these less liquid securities, the Capital
Markets Report explained, liquidity provision and trading activity has declined.17
As a result, the Capital Markets Report recommended the Commission consider whether
to implement regulatory changes aimed at promoting improved liquidity for these companies by
tailoring regulation more appropriately to improve the market for less liquid stocks.18 The
Capital Markets Report noted that equity market regulation over the past 20 years has been
focused on encouraging competition among multiple trading venues in order to improve trade
execution pricing as well as market innovation.19 It pointed to regulatory initiatives such as
Regulation NMS, Regulation ATS, and decimalization, combined with the “electronification” of
the equity markets and the demutualization of stock exchanges into for-profit entities, as
instrumental contributors to the current market landscape.20 In addition, the Capital Markets
Report identified unlisted trading privileges (“UTP”) as a key contributor to the significant
competition among trading venues for secondary market trading volume.21
Although this competition among trading venues has mostly benefited more heavily
traded stocks because the trading volume can support many trading venues, the Capital Markets
Report stated, venue fragmentation can be particularly problematic for thinly traded stocks
because relatively small volumes of trading are spread out among a number of different venues.22
The Report discussed that this fragmented volume makes finding the contra side to a trade more
difficult and can disincentivize market makers to quote in large size on any given trading venue
as they limit their quoting size to better manage their risk.23
In light of these issues, the Capital Markets Report recommended exploring ways to
consolidate liquidity for less liquid stocks on a smaller number of trading venues. Doing so, it

16

Id. at 7.

17

Id. at 49. By way of example, the Capital Markets Report pointed to the liquidity differences between
small- and mid-capitalization stocks and large-capitalization stocks, noting that a Commission staff study
found that, in general, among companies with market capitalizations of less than $5 billion, companies with
less than $100 million capitalization had larger quoted and effective spreads than spreads for those
companies between $2 billion and $5 billion. Id. at 59 (citing Charles Colliver, A Characterization of
Market Quality for Small Capitalization US Equities (September 2014), available at
https://www.sec.gov/marketstructure/research/small_cap_liquidity.pdf). These smaller companies also had
shallower depths of book. Id. However, market capitalization and trading volume are not perfectly
correlated. See infra note 39.

18

See Capital Markets Report, supra note 3, at 49.

19

Id.

20

Id. at 49-53.

21

Id. at 49.

22

Id. at 59.

23

Id. at 60.

4

explained, would simplify the market making process for those securities. In turn, market
makers would be more inclined to provide liquidity in those securities.24
Specifically, the Capital Markets Report recommended the Commission consider
allowing the partial or full suspension of UTP for less liquid stocks and allowing the issuers of
those stocks to select the exchanges and venues on which their stocks would trade until liquidity
in those stocks reached a minimum threshold.25 The Capital Markets Report recommended that
to maintain a basic level of competition for executions, broker internalization (or off-exchange
trading of the stock) should remain available for those thinly traded stocks for which UTP was
restricted.26 In addition, the Capital Markets Report suggested that, among the various measures
of “illiquidity” available, a simple approach to distinguish between liquid and illiquid stocks for
purposes of restricting UTP would be to use ADV.27
C. Securities and Exchange Commission Small Business Advisory Committee
The Commission’s Advisory Committee on Small and Emerging Companies
(“Committee”) was organized to provide advice to the Commission regarding: (1) capital raising
by emerging privately held small businesses and publicly traded companies with less than $250
million in public market capitalization; (2) trading in the securities of such businesses and
companies; and (3) public reporting and corporate governance requirements to which such
businesses and companies are subject.28
On March 23, 2013, the Committee recommended the creation of a separate U.S. equity
market that would facilitate trading in the securities of small and emerging companies as well as
encourage initial public offerings.29 The Committee found, among other things, that the U.S.
equity markets frequently fail to offer a satisfactory trading venue for small and emerging
companies, which (1) has discouraged initial public offerings of the securities of such
companies, (2) undermines entrepreneurship, and (3) weakens the broader U.S. economy.30 The
Committee recommended that the regulatory regime for this separate market be robust to protect
investors but flexible enough to accommodate innovation and growth by these companies.31

24

Id.

25

See id.

26

Id.

27

Id. The OAR Study used ADV as the basis for its analysis of NMS stock trading characteristics. See
Section II.A, above.

28

See Securities and Exchange Commission Advisory Committee on Small and Emerging Companies,
Charter, available at https://www.sec.gov/info/smallbus/acsec/acsec-charter.pdf.

29

See Recommendation Regarding Separate U.S. Equity Market for Securities of Small and Emerging
Companies (February 1, 2013), available at https://www.sec.gov/info/smallbus/acsec/acsecrecommendation-032113-emerg-co-ltr.pdf, at 2.

30

See id. at 1.

31

See id. at 2.

5

D. Review of Economic Literature
The available economic literature includes several analyses of the relationship between
liquidity and trading volume, the effects of market fragmentation on smaller stocks, and the
potential benefits of allowing non-continuous secondary market trading.
1. Liquidity and Trading Volume
Both historically and in more recent years, the economic literature in this area has
consistently documented that stocks with lower trading volume tend to have higher transaction
costs.32 This link between trading volume and liquidity also has been formalized theoretically by
two models in the late 1980s.33 Both models hypothesize that trading volume is linked to
liquidity because as investors become aware that liquidity exists at a certain time or place they
will congregate their trading at those times or places to benefit from the liquidity available there
– thus further enhancing liquidity. Consequently, increased liquidity engenders increased trading
volume which then further enhances liquidity. This effect is what is known as the liquidity
externality.34
2. Liquidity and Capital Formation
Numerous studies have found evidence linking lower liquidity to lower stock prices,35
which suggests that diminished liquidity may also impact stock prices. These analyses show that
investors must be paid a premium in order to hold less liquid stocks. Consequently, thinly traded
securities may have lower stock prices due to diminished liquidity. Additionally, one study
indicates that investment bank fees are significantly lower for more liquid firms indicating that
stock liquidity is a determinant of the cost of raising external capital.36 Another study finds that

32

See Harold Demsetz, The Cost of Transacting, 82 Q. J. ECON. 33 (1968); Michael Barclay & Terrence
Hendershott, Liquidity Externalities and Adverse Selection: Evidence from Trading after Hours, 59 J. FIN.
681 (2005).

33

See Anat Admati & Paul Pfleiderer, A Theory of Intraday Patterns: Volume and Price Variability, 1 REV.
FIN. STUD. 3 (1988); Marco Pagano, Trading Volume and Asset Liquidity, 104 Q. J. ECON. 255 (1989).

34

In certain circumstances, such as around news releases, increased trading volume in a given stock may be
associated with diminished liquidity. See Joon Chae, Trading Volume, Information Asymmetry, and Timing
Information, 60 J. FIN. 413 (2005). However, as a general cross-sectional effect (i.e., certain securities as
compared to other securities), the literature shows that liquidity is generally higher for securities that trade
more often.

35

See Justin Chan, Dong Hong & Marti Subrahmanyam, A Tale of Two Prices: Liquidity and Asset Prices in
Multiple Markets, J. BANKING & FIN. 947 (2008); Yakov Amihud, Haim Mendelson & Lase Pedersen,
Liquidity and Asset Prices, FOUND. & TRENDS IN FIN. 269 (2006); Gady Jacoby, David Fowler & Aron
Gottesman, The Capital Asset Pricing Model and the Liquidity Effect: A Theoretical Approach, 3 J. FIN.
MKT. 69 (2000); Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. FIN.
ECON. 223 (1986) and Yakov Amihud & Haim Mendelson, Liquidity and Stock Returns, 42 FIN. ANALYSTS
J. 43 (1986).

36

See Alexander W. Butler, Gustavo Grullon & James P. Weston, Stock Market Liquidity and the Cost of
Issuing Equity, 40(2) J. FIN. & QUANT. ANAL. 331 (2005).

6

that stock liquidity reduces firm default risk by improving stock price informational efficiency
and facilitating corporate governance by blockholders.37
3. Market Fragmentation
Market fragmentation is generally studied as either fragmentation between exchange and
non-exchange trading venues or as among exchanges. Academic views on the effects of market
fragmentation among exchanges for small stocks are mixed. For example, one analysis uses U.S.
data and finds cross-sectional evidence suggesting that increased exchange fragmentation is
beneficial to liquidity for small stocks.38 However, another analysis uses European data and a
panel dataset and finds the opposite to be the case.39
The literature examining fragmentation between exchange and non-exchange trading
venues is likewise mixed. For example, one theoretical study hypothesizes that an off-exchange
venue alongside a consolidated exchange may facilitate large block trades. This would suggest
that fragmentation between exchange and non-exchange trading venues may be beneficial to
market quality as it enables investors of different types to more readily find one another (i.e.,
large block traders will go to the non-exchange trading venues, while smaller traders will
congregate on the exchanges).40 Consistent with this, another study using Australian data finds
that block trading off-exchange does not harm price discovery on exchanges. This study also
finds that when the total level of off-exchange trading grows too high, it harms price discovery
on exchanges, harming market quality.41 Another study examines the impact of an exogenous

37

See Jonathan Brogaard, Dan Li & Ying Xia, Stock Liquidity and Default Risk, 124(3) J. FIN. ECON. 486
(2007). Some academic literature addresses how liquidity impacts corporate decisions and behavior. This
literature does not provide a consistent relation between liquidity and the quality of corporate decisions, but
rather suggests various reasons why and circumstances under which liquidity or illiquidity may improve or
harm the quality of corporate decisions. See, e.g., Vivian W. Fang, Thomas H. Noe & Sheri Tice, Stock
Market Liquidity and Firm Value, 94(1) J. FIN. ECON. 150 (2009); Amar Bhide, The Hidden Costs of Stock
Market Liquidity, 34(1) J. FIN. ECON. 31 (1993).

38

See Maureen O’Hara & Mao Ye, Is Market Fragmentation Harming Market Quality?, 100 J. FIN. ECON.
459 (2011) (“O’Hara and Ye Study”).

39

See Carole Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity, 35C J. FIN. MKTS. 1 (2017).
Both this study and the O’Hara and Ye Study use market capitalization as opposed to ADV to define small
stocks; however, market capitalization and trading volume are positively related, although not perfectly so.
Consequently, these studies can provide an idea of what may be expected among thinly traded securities.

40

See Pagano, supra note 33.

41

See Carole Comerton-Forde & Tālis J. Putniņš, Dark Trading and Price Discovery, 118 J. FIN. ECON. 70
(2015).

7

decline in non-exchange trading on trading volume for small stocks and finds no impact on
execution quality.42
4. Potential Impact of Non-Continuous Trading
Some of the economic literature assesses the impact non-continuous trading may have on
a market. For example, an alternative to a continuous trading market is a batch auction whereby
at discrete points in time during the trading day the market holds an auction. According to this
research, batch auctions may improve liquidity, particularly for thinly traded securities, by
concentrating liquidity at certain points in time.43 The research characterizes the tradeoff with
continuous trading as the loss of continuity in trading and the costs of gathering market
information that would otherwise be revealed through price quotations.44 However, auctions
may fail in consolidating liquidity and improving price efficiency. As two studies argue, when
there is insufficient order flow or significant order imbalances, auctions lose their efficiency.45
These studies generally assume that for a periodic batch auction to be effective, trading needs to
be consolidated onto one exchange. However, another study argues that under certain conditions
a continuous market can be implemented effectively alongside a periodic batch auction.46
E. SEC Staff Roundtable on the Market Structure for Thinly Traded Securities
In April 2018, Commission staff convened the Roundtable on thinly traded securities.
Roundtable participants and commenters discussed the challenges of trading thinly traded equity
securities, as well as potential improvements to the existing equity market structure that might be
considered to facilitate secondary market trading in these securities.47 As discussed in detail
below, Roundtable participants and commenters generally agreed that the unique characteristics
of the thinly traded segment of the equity market create different challenges than for the actively
traded segment of the market, where the vast majority of trading occurs. While Roundtable
participants and commenters expressed a range of views, they largely expressed concern that the
existing equity market structure is not optimal for thinly traded securities, especially corporate
common stock. Some expressed concern about the declining number of small publicly listed and
traded companies in the U.S., echoing the Capital Markets Report assertion that the current

42

See Ryan Farley, Eric Kelley & Walter Puckett, Dark Trading Volume and Market Quality: A Natural
Experiment, Working Paper (2018), available at
https://www1.villanova.edu/content/dam/villanova/VSB/assets/marc/marc2018/SSRN-id3088715.pdf.

43

See Robert Schwartz & Reto Francioni, Call Auction Trading, Encyclopedia of Finance 477 (2013).

44

See Ananth Madhaven, Trading Mechanisms in Securities Markets, 47 J. FIN. 607 (1992).

45

See Ananth Madhaven & Venkatesh Panchapagesan, Price Discovery in Auction Markets: A Look Inside
the Black Box, 13 REV. FIN. STUD. 627 (2000); Schwartz & Francioni, supra note 43.

46

See Eric Budish, Peter Cramton & John Shim, Implementation Details for Frequent Batch Auctions:
Slowing Down Markets to the Blink of an Eye, 104 AM. ECON. REV. 418 (2014).

47

See Roundtable, supra note 4.

8

market structure works quite well for liquid names but is inadequate for illiquid names,48 and that
more needs to be done to promote liquidity and to improve the listing and trading environment
for thinly traded stocks.49 Roundtable participants and commenters discussed how the secondary
markets for thinly traded securities operated for a variety of market participants, including
issuers, institutional investors, and market makers, as well as the different characteristics of
trading thinly traded ETPs.
1. Issuers
One Roundtable participant, based on his discussions with small-cap issuers in advance
of the Roundtable, identified the effect on capital formation of changes in attitudes towards
thinly traded securities since before the financial crisis of 2008.50 Specifically, he highlighted
the move over the course of the past decade from investor interest in learning about the
underlying quality of a more thinly traded issuer to investor interest in learning about how
quickly a position in that security could be liquidated.51 In particular, he expressed concern
about the challenges in attracting growth capital that these changing attitudes have created for
this segment of the market.52 The ability to access capital and the terms of such financing are
inextricably tied to trading volume, he explained.53 He noted that investors look to the most
liquid names, rather than to the company stocks that might best meet their portfolio needs.54 He
stated that when prospective issuers need to raise growth capital, fund managers estimate the
percentage of market cap that an issuer will be able to raise by evaluating the volume of stock
traded.55 He indicated that this process makes it challenging for issuers to raise needed capital.56
The Roundtable discussion also explored how a company whose stocks are thinly traded
may suffer not only in its more limited access to capital formation, but also in its day-to-day and
long term operations and overall corporate health. The same Roundtable participant expressed
his belief that trading illiquidity may significantly impact less capitalized companies by limiting
their ability to obtain research coverage and to participate in the mergers and acquisitions
market.57

48

See Transcript, supra note 8, at 48 (Mr. Bryan Harkins, Executive Vice President and Head of U.S.
Markets, CboeBZX).

49

See id. at 27 (Mr. Frank Hatheway, Chief Economist, Nasdaq OMX Group, Inc.).

50

See id. at 50 (Mr. Adam Epstein, Founder, Third Creek Advisors).

51

See id. at 51 (Mr. Epstein).

52

See id. (Mr. Epstein).

53

See id. (Mr. Epstein).

54

Id. at 21 (Mr. Epstein).

55

See id. at 52 (Mr. Epstein).

56

See id. (Mr. Epstein).

57

Id. at 22 (Mr. Epstein).

9

He also explained that low trading has a negative impact on a company’s relationships
with its customers, vendors, and partners, as well as potentially harming its ability to hire and
retain high quality employees.58 In particular, when potential and existing employees have a
negative perception of a company’s future prospects because they are looking at its perceived
health through the lens of its trading volume and trading volatility, the company potentially can
find it more difficult to attract and retain qualified employees.59 Similarly, it can be more
difficult to contract with reliable vendors and suppliers at favorable rates.60 The additional
burdens that are placed on less liquid companies can be stifling, negatively affecting the
companies’ operations and potentially resulting in fewer opportunities for such companies to
become more liquid in the secondary markets going forward.61 None of the other Roundtable
participants or commenters expressed contrary views.
2. Institutional Investors
Several Roundtable participants noted that the challenges in trading thinly traded
securities are compounded by the self-perpetuating nature of the problem of illiquidity.62 For
example, one Roundtable participant representing the buy side (institutional investment
management firm) pointed to the prevalence and popularity of passive investments in the market
as a factor that has bifurcated the market.63 He noted that the penalty imposed on a less liquid
security that is not selected as a component of a frequently traded index is fewer trades and,
consequently, less liquidity.64 Another Roundtable participant representing a large retail brokerdealer agreed, noting that the factors that primarily contribute to low liquidity are small floats,
highly convicted owners of those securities (i.e., owners that are inclined to hold), and lack of
index inclusion.65 These factors may exacerbate what a number of Roundtable participants
highlighted as a general reluctance by institutional investors to invest in thinly traded securities.

58

See id. (Mr. Epstein).

59

See id. at 22, 85 (Mr. Epstein). For example, he noted anecdotally, experienced potential or existing
employees will leave or disregard smaller companies that offer less trading liquidity and higher trading
volatility because they determine those issuers’ stocks do not offer adequate opportunities to monetize their
stock options. Id. at 85-86 (Mr. Epstein).

60

Id. at 22, 85 (Mr. Epstein). Smaller companies with few choices in suppliers and little leverage to negotiate
vendor agreements may find themselves at odds with a supplier’s credit and risk tolerance thresholds
entirely based on trading illiquidity rather than on the company’s fundamentals. See id. at 86 (Mr. Epstein).

61

See id. at 22, 85-86 (Mr. Epstein).

62

See, e.g., id. at 34 (Mr. Jason Vedder, Director of Trading and Operations, GTS Capital Management), 108
(Mr. Brian Frambes, Co-Head Global Cash Trading, Fidelity Management & Research Co.).

63

See id. at 34 (Mr. Vedder).

64

See id. at 34-35 (Mr. Vedder).

65

See id. at 108 (Mr. Frambes).

10

A key issue for institutional investors is the perceived difficulties they may encounter in
attempting to unwind a position taken in a thinly traded security.66 One Roundtable participant
representing an institutional broker-dealer trading (sell side) noted in particular the dissonance
resulting from the fact that the demand to acquire a position is generally more patient than the
demand to unwind a position.67 According to another Roundtable participant, representing a
national securities exchange, issuers of thinly traded securities listing on his exchange frequently
hear that institutional investors may be interested in their companies, but then are confronted by
those investors’ concerns about being able to trade in and out of the stock.68 To the extent that
this concern presents an impediment to investing, he noted, it only perpetuates the perceived
limitations of the marketability of these securities.69
A Roundtable participant representing the sell side described the difficulty his firm has
encountered in accessing liquidity in these types of securities for his firm’s clients, stating that
the liquidity of the markets does not really meet that demand.70 Similarly, one Roundtable
participant representing the buy side described in detail the challenges that he faces routinely in
attempting to fill customer orders for thinly traded securities. He indicated that he would first
attempt to trade whatever percentage of the order that he could off-exchange.71 After that, he
noted, it becomes a “cat and mouse game” where he needs to shift from venue to venue in search
of a fill.72 The result, he said, is that market participants end up battling others trying to access
that market space, and they are eager to glean any information about how competitors are
entering the market.73 He expressed frustration that to get merely 10 percent of a trade
completed, he has to go to multiple exchanges.74 In his view, the market has gone from being a
negotiated market to one where market participants hunt across venues for limited pockets of
liquidity.75 Another Roundtable participant speaking from an asset manager perspective echoed
the observation that it takes longer to trade and find liquidity in small capitalization stocks than it
does for large capitalization stocks.76 Other Roundtable participants, representing the sell side
and a national securities exchange, agreed that in trading thinly traded securities, there are

66

See id. at 35 (Mr. Vedder).

67

See id. at 37 (Mr. Brian Fagen, Head of Execution Strategy for Equities, Deutsche Bank).

68

See id. at 45 (Mr. Hatheway).

69

See id. (Mr. Hatheway).

70

See id. at 36 (Mr. Fagen).

71

See id. at 53 (Mr. Vedder).

72

Id. at 53-55 (Mr. Vedder).

73

Id. at 53-54 (Mr. Vedder).

74

See id. at 54 (Mr. Vedder).

75

See id. at 54-55 (Mr. Vedder).

76

See id. at 154 (Mr. Frambes).

11

challenges created by an investor’s interest in finding liquidity where there is no interest on the
other side of the transaction at the time that liquidity is being sought.77
One Roundtable participant representing a large market maker questioned whether the
challenges described in accessing liquidity were caused more by timing dislocation, where there
is a limited number of, or a lack of, diverse holders of the name at any given time, rather than
geographic fragmentation caused by multiple venues.78 One commenter, providing the view of
an equity trading platform, elaborated on the idea that this “temporal fragmentation” is the root
cause of small capitalization stock illiquidity.79 Investors are wary of placing limit orders and
waiting for executions, the commenter explained, due to concerns about perceived information
leakage and adverse selection.80 Although the Commission should not consider self-interested
proposals for regulatory action, the commenter cautioned, the Commission should consider
whether the prevailing market model – displayed liquidity in continuous markets – is truly
appropriate for all small companies.81 Some stocks, the commenter explained, may benefit from
privately negotiated trades or trading in public auctions that seek to mitigate the temporal
fragmentation.82 The commenter also stated that the Order Protection Rule under Regulation
NMS dampens innovation in the markets, which disadvantages these securities, noting that in
many cases what market participants are willing to display bears little relation to what they are
willing to transact.83
One Roundtable participant, representing the buy side, discussed at the length the effort
required to try to locate interest on the other side of the market of a potential trade.84 He
explained that, in thinly traded securities that trade 100,000 shares, there likely will be only two
to three participants in the marketplace, at most, who would take the counter side to his orders.85
Another Roundtable participant, representing a large market maker, emphasized the difficulties
caused by the wide variety of market participants, each of whom may have a different time
horizon and varied reasons to trade, and each of whom may employ different risk and reward
metrics in its decision-making processes.86

77

See id. at 98 (Mr. Chris Concannon, then-President and Chief Operating Officer, Cboe Global Markets,
Inc.), 135-36 (Mr. Joseph Mecane, Head of Execution Services, Citadel Securities).

78

See id. at 57 (Mr. Steve Cavoli, Senior Vice President, Global Execution Services, Virtu Financial).

79

See Letter from Don Ross, Chief Executive Officer, PDQ Enterprises, LLC (May 10, 2018), available at
https://www.sec.gov/comments/265-31/26531-3619683-162360.pdf (“PDQ Letter”).

80

Id. (PDQ Letter).

81

Id. at 1-2 (PDQ Letter).

82

Id. at 2 (PDQ Letter).

83

Id. at 3 (PDQ Letter).

84

See Transcript, supra note 8, at 53 (Mr. Vedder).

85

See id. (Mr. Vedder).

86

See id. at 57 (Mr. Cavoli).

12

Speaking more generally about the trading challenges raised by thinly traded securities, a
number of Roundtable participants agreed that the information cost of attempting to access
liquidity in thinly traded securities was too high. One Roundtable participant, representing the
sell side, described it as one of the biggest costs that his firm incurs, not only because of the
actual cost of the trade itself, but the cost of finding that liquidity.87 Other Roundtable
participants generally agreed that this impact is markedly more significant in the thinly traded
segment of the market where there is less likelihood of obtaining an execution quickly, if at all.88
Another Roundtable participant from one of the exchanges noted that this is an issue for both onexchange and over-the-counter (“OTC”) trading in this segment of the market.89
One commenter, representing the buy side, noted that, although order flow competition
has benefited investors by incentivizing various trading venues to reduce costs and improve the
quality of their products and services to a high level,90 the approach may not be optimal for
thinly traded securities.91 More specifically, the commenter stated that although having 13
national securities exchanges and UTP in place “fosters continuity, resilience, innovation, and
exchange fee competition,” the consequent liquidity fragmentation may be ineffective for those
securities traded infrequently or at consistently lower volumes.92 Of the 4,000 corporate
common stocks listed on the major U.S. exchanges, the commenter identified approximately 20
percent in 2017 as having an ADV of 50,000 shares or less, representing 35 basis points of dollar
turnover, and with a median bid-ask spread of 234 basis points versus a median of 36 basis
points for corporate common stocks overall.93 In the current market structure, the commenter
explained, these thinly traded securities generally have higher transaction costs for investors.
The national securities exchange Nasdaq, Inc. (“Nasdaq”), submitted to the Commission
and placed in the Roundtable comment file an application to the Commission (the “Nasdaq
Application”) under Section 12(f) of the Securities and Exchange Act (“Exchange Act”). The
Nasdaq Application stated that in more active (and typically large) stocks, the displayed quote is
narrow, often the one cent minimum, and changes in the NBBO for those securities are
frequent.94 According to Nasdaq, in such conditions, resting limit orders are likely to become

87

See id. at 60 (Mr. Fagen).

88

See id. at 62 (Mr. Vedder).

89

See id. at 121 (Ms. Stacey Cunningham, then-Chief Operating Officer, NYSE Group).

90

See Letter from Nathaniel N. Evarts, Managing Director, Head of Trading, Americas, State Street Global
Advisors and David LaValle, Managing Director, US Head of ETF Capital Markets, Global SPDR
Business (April 12, 2018) (“State Street Letter”).

91

Id. at 2 (State Street Letter).

92

Id. (State Street Letter).

93

Id. at 3 (State Street Letter).

94

See Application to Permit Issuer Choice to Consolidate Liquidity by Suspending Unlisted Trading
Privileges (April 25, 2018), available at https://www.sec.gov/comments/265-31/26531-3515735162293.pdf, at 11. The Nasdaq Application requests that the Commission suspend, for a period of up to 12
months, UTP for certain Nasdaq-listed securities. More specifically, Nasdaq requested that the
Commission restrict UTP for Nasdaq-listed securities that are: (1) issued by an operating company; (2)

13

marketable; for the most active issues the likelihood was as high as 90 percent that a limit order
priced at the inside bid or offer would become marketable within thirty minutes of submission.95
By contrast, in less active (and typically small) stocks, the quote is wide and changes less often;
displayed limit orders rarely become marketable due to changes in the quote and executions are
primarily triggered by the appearance of an opposing aggressive order.96
The Nasdaq Application also provides an analysis of the impact of fragmentation by
looking at the actual experience of a sample of inactive stocks (daily volume less than 100,000
shares).97 The Nasdaq Application identified 791 episodes where: (1) an exchange set a new
inside quote in a less active stock (a higher national best bid or lower national best offer); (2) the
quote-setting exchange was subsequently joined at the quote-setting price by at least one other
exchange, and (3) at least one trade occurred at the quote-setting price. In these instances, the
quote-setting exchange traded in only 31 percent of the cases.98 Nasdaq found that in the
remaining 69 percent of cases where the quote-setting exchange did not trade, another exchange
traded in 29 percent of the cases, an OTC venue traded in 32 percent of the cases, and both
another exchange and an OTC venue traded in 8 percent of the cases.99 Nasdaq therefore
concluded that the submitter of the price-improving limit order was not necessarily rewarded
with an execution.100 Nasdaq also found that, based on data for 561 Nasdaq-listed securities with
less than 1 million shares outstanding on October 10, 2017, on average, one market was alone at
the best price 65 percent of the time for stocks with ADV of 10,000 shares or less; by
comparison, one market was alone at the best price 38 percent of the trading day for stocks with
ADV between 10,000 and 100,000 shares and 18 percent of the trading day for stocks with ADV
between 100,000 and 1,000,000 shares.101
Another commenter, representing the views of proprietary trading firms, agreed that
trading venue fragmentation is a reason why many stocks have wide spreads and low trading

have an initial market capitalization of $700 million or less or a continued market capitalization of $2
billion or less; (3) have an initial ADV of 100,000 shares or less; and (4) have a bid price greater than $1.
In addition, Nasdaq proposed to remove quotation and trading activity in these securities from the revenue
allocation formula for the Nasdaq UTP Plan. Nasdaq indicated market structure innovations it might
implement for these securities, upon the restriction of UTP, could include periodic auctions, market maker
incentives, and tick and lot size variation. Under the Nasdaq Application, a security that no longer fits the
criteria for UTP suspension would be restored to regular trading requirements within 6 months. Nasdaq
explained that doing so would incentivize the exchange to implement exchange structure innovations for
thinly traded securities aimed at improving liquidity and secondary market trading in those securities. See
id. Nasdaq did not propose to restrict OTC trading. See id. at 17.
95

See id. (Nasdaq Application).

96

See id. (Nasdaq Application).

97

See id. (Nasdaq Application).

98

See id. (Nasdaq Application).

99

See id. at 11-12 (Nasdaq Application).

100

See id. at 12 (Nasdaq Application).

101

See id. at 15 (Nasdaq Application).

14

turnover, but also identified other factors he thought affected liquidity in thinly traded stocks and
that the Commission should consider.102 Only by addressing these factors, the commenter stated,
will liquidity in these stocks increase and bid-ask spreads narrow.103 One factor the commenter
noted is the risks and costs associated with providing liquidity in thinly traded stocks, which in
turn informs the bid-ask spread. Because the bid-ask spread reflects an equilibrium point at
which a liquidity provider finds a positive rate of return, the commenter explained, identifying
and reducing the risks and costs of making a two-sided market in those securities can help
narrow those spreads and incentivize market makers to provide liquidity.104 A number of the
risks and costs the Roundtable commenter identified are internal to a liquidity provider, such as
licensing, cost of capital, or trading losses.105 Others, however, are related to the current market
structure and trading expectations in the equity markets, such as the execution risk due to a
complicated market structure, technology costs due to the current market structure focus on
speed and automation, and connectivity, and market data costs due to venue fragmentation in the
equity markets.106
3. Role of the Over-the-Counter Market
Roundtable participants and commenters also discussed the role OTC trading plays for
thinly traded securities, including benefits to retail investors and block size transactions. One
Roundtable participant representing the retail buy side noted that the prevalence of OTC trading
for thinly traded securities was beneficial to retail investors and did not result in detrimental
execution quality.107 Instead, he stated that retail investors generally receive price improvement
and enhanced liquidity when transacting off-exchange in thinly traded securities.108 He also said
that retail investors are not necessarily concerned with liquidity when they transact in thinly
traded securities.109 Other Roundtable participants, representing the sell side and a national
securities exchange, respectively, noted that the amount of price improvement delivered to retail
investors off-exchange is material and care should be taken so that it is not negatively impacted
by any of the market structure changes discussed at the Roundtable.110 Other Roundtable
participants representing national securities exchanges, however, cautioned against addressing

102

See Letter from Daniel Schlaepfer, President, Select Vantage (April 20, 2018), available at
https://www.sec.gov/comments/265-31/26531-3489072-162255.pdf (“Select Vantage Letter”).

103

Id. at 2 (Select Vantage Letter).

104

Id. at 1 (Select Vantage Letter).

105

See id. (Select Vantage Letter).

106

See id. at 1-2 (Select Vantage Letter).

107

See, e.g., Transcript, supra note 8, at 30 (Mr. Ovi Montemayor, Managing Director of Financial Market
Services, TD Ameritrade), 38-39 (Mr. Montemayor).

108

See id. at 38-39 (Mr. Montemayor).

109

Id. (Mr. Montemayor).

110

See id. at 133 (Mr. Mecane). See also id. at 147 (Mr. Concannon).

15

liquidity concerns on-exchange without addressing the same issues in the OTC market.111 Some
Roundtable participants, representing both the buy side and the sell side, noted that OTC trading
provided similar benefits to large size trades, for which the information leakage discussed above
can become particularly problematic.112 In particular, a Roundtable participant representing the
sell side noted that institutional investors with large order flow seek to control information
leakage and costs, and dark pools provide an efficient and inexpensive transaction with the least
amount of information leakage.113
One commenter, representing the sell side, stated that the existence of competitive
markets and, in particular, the prominent role of the OTC market in providing liquidity for thinly
traded securities, benefits investors.114 The commenter stated that retail investors account for a
significant percentage of the trading in thinly traded securities and benefit principally from the
availability of OTC trading. For example, the commenter noted, from September 2017 to
February 2018, based on Regulation NMS Rule 605 data as compared to total trading volumes,
retail investors constituted 18 percent of the trading activity in thinly traded securities.115 The
commenter also explained that OTC trading allows investors to effect larger transactions without
market impact and with lower transaction costs and spreads. More specifically, the commenter
stated, the ability of market makers to commit capital in size and provide price improvements is
a result of the non-displayed and bilateral nature of market making in the OTC markets.116 The
commenter cautioned that market structure changes aimed at addressing on-exchange liquidity
could disrupt the OTC markets and negatively impact investors, so any such changes should be
structured to leave the OTC market unaffected.117
Another commenter, representing a national securities exchange, also noted that the OTC
markets represent a significant percentage of the thinly traded securities market, but stated
instead that, consequently, steps to address market fragmentation and improve liquidity for thinly
traded securities should apply to both on-exchange and OTC trading.118 The commenter
explained that OTC trading in this market segment currently is more fragmented than trading on
non-primary exchanges, noting that 13 percent of share volume in thinly traded securities is
traded across 18 alternative trading systems (“ATSs”), and a further 26 percent of share volume
111

See id. at 102 (Ms. Cunningham), 105 (Mr. Brad Katsuyama, Co-founder and Chief Executive Officer,
IEX), 121 (Ms. Cunningham).

112

See id. at 69-70 (Mr. Cavoli), 132 (Mr. Owain Self, Global Head of Execution Services, Millennium
Management).

113

See id. at 70 (Mr. Ari Rubenstein, Co-founder and Chief Executive Officer, GTS).

114

See Letter from Douglas A. Cifu, Chief Executive Officer, Virtu Financial (April 20, 2018), available at
https://www.sec.gov/comments/265-31/26531-3488782-162247.pdf (“Virtu Letter”), at 3.

115

Id. (Virtu Letter).

116

Id. (Virtu Letter).

117

Id. at 2-3 (Virtu Letter).

118

See Letter from Elizabeth K. King, General Counsel and Corporate Secretary, New York Stock Exchange
(November 20, 2018), available at https://www.sec.gov/comments/265-31/26531-4668089-176554.pdf
(“NYSE Letter”).

16

is executed on non-ATS OTC venues.119 In addition, the commenter stated that thinly traded
securities are less fragmented across exchanges than more actively traded securities, with the
primary listing exchanges for those securities accounting for 43.5 percent of the total share
volume quoted at the NBBO based on the commenter’s data set.120
4. Market Makers
Several Roundtable participants and commenters discussed the role of market makers in
facilitating trading in thinly traded securities. One Roundtable participant, representing an
academic perspective, discussed the fragility of liquidity and linked it to a lack of affirmative
market maker obligations. He stated that without affirmative obligations, market makers’
participation tends to be highly correlated with each other, rather than related to the needs of the
individual securities in this segment of the market or the market as a whole.121 As a result, he
stated, during favorable market conditions, there is a lot of market maker participation; by
contrast, when market conditions are unfavorable for market making activities, market makers
scale back in unison.122 This behavior is economically sensible, he noted, because on a riskadjusted basis, unfavorable market conditions indicate it is not particularly profitable to make
markets.123
According to this Roundtable participant, from a regulatory perspective as well as from an
issuer or investor perspective, this results in an unstable supply of liquidity where the
counterparty may not be on the other side of a trade.124 He observed that, although this problem
is not unique to thinly traded securities, it is particularly relevant for small capitalization stocks
because unfavorable trading conditions that make market makers step away, such as low volume
or one-sided order flow, happen more frequently for these stocks than for large capitalization
stocks.125 He stated that this is the result market participants should expect in a situation where
market makers do not have affirmative obligations and where it is not particularly profitable to
make markets in thinly traded stocks.126

119

Id. at 2 (NYSE Letter).

120

Id. (NYSE Letter). The commenter also noted that its calculations of the Herfindahl-Hirschman Index (a
measure of market participant activity concentration) for February 2018 indicated a high degree of
concentration for quoting activity across the exchanges for thinly traded securities as opposed to a moderate
degree of concentration for more actively traded stocks. Id. at 3 (NYSE Letter). For trading activity across
exchanges and some ATSs, the commenter also calculated a high degree of concentration for thinly traded
securities. Id. at 3-4 (NYSE Letter).

121

See Transcript, supra note 8, at 192-93 (Mr. Kumar Venkataraman, Professor of Finance, Cox School of
Business, Southern Methodist University).

122

See id. (Mr. Venkataraman).

123

See id. (Mr. Venkataraman).

124

See id. at 193 (Mr. Venkataraman).

125

See id. (Mr. Venkataraman).

126

See id. (Mr. Venkataraman).

17

Another Roundtable participant, representing a national securities exchange, echoed the
concern about the difficulty in finding liquidity in thinly traded securities particularly during
adverse trading conditions, asserting that market makers today would be fairly exposed to risk
during times of volatility if they did not pull out of unfavorable markets quickly.127 In his view,
a key way to address this issue would be to adopt a market model in which market makers with
affirmative quoting obligations would have additional incentives that would help to ensure that
they would comply with such obligations not only during normal market conditions, but also
during times of duress.128 Another Roundtable participant, representing the sell side, echoed this
concern during the discussions, noting that seeking liquidity in this range of securities is
comparatively challenging, especially during times of market stress or other times of illiquidity
that arise around significant events.129
Other Roundtable participants, representing the sell side and national securities
exchanges, also commented on the difficulty of making markets in thinly traded securities and
possible ways to incentivize market maker involvement. One Roundtable participant from the
sell side advocated amending the rules governing market makers, pointing specifically to the
impediments to providing liquidity caused by short selling restrictions.130 Another Roundtable
participant, representing a national securities exchange, asked whether exchanges could better
link the economic rewards resulting from making markets in liquid names to an obligation to
facilitate trading in illiquid securities.131
Another Roundtable participant, representing the buy side, regretted that the traditional
operations of market makers have disappeared today because of the challenges presented by
venue fragmentation.132 He stated that many regional firms do not make markets in this segment
of the market because it is difficult to profit from providing liquidity in thinly traded securities
when they are much more volatile than a well-established, highly liquid security.133 He also
stated that the current NMS model has disserviced this segment of the marketplace because it has
impeded relationships and communication between individual firms placing trades and market
makers. As a result, trading in this segment of the market is now less transparent than it was
when market participants fostered relationships with market makers and could communicate
about their trading intentions.134

127

See id. at 150 (Mr. Tal Cohen, Senior Vice President, North American Equities, Nasdaq).

128

See id. at 150-52 (Mr. Cohen).

129

See id. at 24 (Mr. Fagen).

130

See id. at 71-72 (Mr. Rubenstein). He described a situation in which their systems were bound by these
requirements, resulting in less liquidity in the markets at the expense of investors, right when there was
enormous demand for liquidity. See id. at 52.

131

See id. at 49 (Mr. Harkins).

132

See id. at 74 (Mr. Vedder).

133

See id. (Mr. Vedder).

134

See id. at 74-75 (Mr. Vedder).

18

One commenter, representing the buy side, stated that another key factor affecting
liquidity in thinly traded securities is the difficulty of using automated systems for market
making in these securities.135 Previously, human market makers were obligated to make markets
in a range of stocks, including less liquid stocks, the commenter explained; whereas currently,
market liquidity largely is provided by firms operating automated systems with no obligation to
support less liquid stocks.136 Because per-share profitability is lower, and trading frequency is
higher, the commenter stated, these liquidity providers concentrate their trading in highervolume securities.137
5. Thinly Traded Exchange Traded Products
Roundtable participants and commenters also discussed issues and concerns related to the
secondary market trading of thinly traded ETPs. In particular, Roundtable participants and
commenters discussed whether the same liquidity considerations are a significant factor for
investments in ETPs or whether other factors are equally or more relevant to ETP secondary
market trading determinations.
For ETPs, one commenter, representing the buy side, identified 60 percent of the 2,147
U.S.-listed products as having an ADV of 50,000 shares or less, representing 1 percent of total
dollar turnover, and with an average bid-ask spread of 33 basis points versus 8 basis points for
the more actively traded ETPs.138 The commenter noted, though, that the liquidity characteristics
of an ETP’s underlying constituents also should be considered in assessing ETP liquidity.139 A
number of Roundtable participants made similar observations, noting that, as opposed to a
corporate stock, an ETP that is thinly traded may still be highly liquid, and that therefore the
level of secondary market trading does not correlate as closely with liquidity as it does for
corporate stocks. One Roundtable participant representing the buy side asserted that for ETPs,
being thinly traded does not equate to being illiquid because traditional measures of liquidity
such as ADV or the size of the quoted spread are not necessarily the best measurements of
liquidity for an ETP.140 Assessing the liquidity of an ETP instead involves assessing the liquidity
profile and the tradability of the ETP’s underlying reference assets.141 Another Roundtable
participant, representing a national securities exchange, asserted that even the illiquidity of some
of the underlying reference assets for an ETP may not necessarily create a liquidity problem for

135

See Select Vantage Letter, supra note 102, at 2.

136

See id. (Select Vantage Letter).

137

Id. (Select Vantage Letter). In particular, as opposed to rebates for more actively traded securities, the pershare rebates provided by exchanges generally are insufficient to compensate for the greater risk of
providing liquidity for thinly traded securities. Id.

138

See State Street Letter, supra note 90, at 3.

139

See id. (State Street Letter).

140

See Transcript, supra note 8, at 179 (Mr. David LaValle, U.S. Head of SPDR ETF Capital Markets, State
Street Global Markets).

141

See id. (Mr. LaValle).

19

the ETP itself because ETP market makers often address illiquidity in the underlying reference
assets by using derivatives to hedge their positions.142
Another Roundtable participant representing the buy side commented that, although there
are many equity market structure commonalities between corporate stocks and ETPs, liquidity
for ETPs is more nuanced because of the primary market issuance process for ETPs.143 Because
ETPs have a regular daily creation and redemption function that corporate stocks do not have, he
explained, an ETP investor or an ETP market marker can increase or decrease the supply of ETP
shares in the market place on a daily basis.144 As a result, he stated, as a practical matter, ETPs
have “unlimited liquidity” and an ETP can be both thinly traded and very liquid at the same
time.145 In effect, Roundtable participants explained, there are two layers of liquidity: there is
the secondary market trading of the ETP, but the principal liquidity backstop for ETPs is the
creation and redemption mechanism.146 Because of this dynamic, some of the Roundtable
participants representing market maker interest explained there are no ETPs that are “too illiquid
to touch.”147
Instead, several Roundtable participants representing market makers and national
securities exchanges noted that a larger concern for thinly traded ETPs is the lack of flexibility in
creation and redemption unit sizes. If there were smaller creation and redemption unit sizes, one
market maker Roundtable participant commented, market makers then could facilitate trading in
smaller size for less frequently traded ETPs, which may have wider spreads than other ETPs.148
These wider spreads reflect, among other considerations, the risk and cost of holding and
hedging large size creation units and holding the hedge on the other side of the trade. As a
result, facilitating small retail trades is quite costly.149 Another Roundtable participant
representing market makers explained that determining how widely to quote an ETP is a function
of factors such as creation and redemption sizes, creation and redemption fees, and the
availability of authorized participants in the ETP.150 He also noted that from his perspective, the
most noteworthy characteristic of less liquid ETPs is that spreads are much tighter at larger trade

142

See id. at 200 (Mr. Phil Mackintosh, Global Head of Economics and Research, Nasdaq).

143

See id. at 190 (Mr. Charles Thomas, Head of U.S. ETF Capital Markets, Vanguard Group Inc.).

144

See id. (Mr. Thomas).

145

Id. (Mr. Thomas).

146

See id. at 208 (Mr. Thomas).

147

Id. at 203-04 (Mr. Greg Sutton, Managing Director, Citigroup Global Markets Inc.), 208 (Mr. Thomas).

148

See id. at 209 (Mr. Josh Kulkin, Head of Trading, Jane Street Capital LLC).

149

See id. at 182 (Mr. Mackintosh).

150

Id. at 177 (Mr. Kulkin). An authorized participant is an ETP liquidity provider who is permitted to create
or redeem ETP shares directly with the ETP fund.

20

sizes due to creation and redemption sizes and minimum creation and redemption size
requirements.151
III. Current Regulatory Framework for Thinly Traded Securities
A.

Unlisted Trading Privileges

As discussed in the Commission Statement, potential market innovation to improve
secondary market trading in thinly traded securities may implicate Section 12(f) of the Securities
Exchange Act of 1934 (“Exchange Act”).152 Section 12(f) permits securities listed on any
national security exchange to be traded by other such exchanges.153 Enacted in 1936, when a
market structure that differs significantly from today’s market structure existed, amendments to
this provision and the rules promulgated thereunder have been aimed largely at streamlining the
UTP process without substantially altering the basic principles underlying its adoption.154
Prior to the enactment of Section 12(f), there was significant Commission and
Congressional concern about the prevalence of unlisted securities and the potential for
speculation regarding, and manipulation of, such unlisted securities.155 Congress and the
Commission were also concerned, however, about supporting intermarket competition and, to
that end, ensuring the survival of the regional exchanges in the face of the New York Stock
Exchange’s (“NYSE”) market dominance.156 This desire to foster and maintain competition
among the exchanges was central to the Commission’s recommendation to continue to permit the
151

See id. (Mr. Kulkin).

152

15 U.S.C. 78l(f).

153

Currently, UTP is automatically extended to a security when at least one transaction in a security that is the
subject of an IPO has been effected on the national securities exchange on which the security is listed and
the transaction is reported under an effective transaction reporting plan. See Securities Exchange Act
Release No. 43217, 65 FR 53560 (September 5, 2000) (eliminating the one day waiting period for
exchanges to extend UTP to listed IPOs).

154

Section 12(f) of the Exchange Act as initially enacted required the Commission to “make a study of trading
in unlisted securities upon exchanges” and to report the findings and recommendations to Congress before
January 3, 1936. See Pub. L. 290, 73rd Cong., as Approved June 6, 1934, 48 Stat. 881. The Commission
provided Congress with the Report on Trading in Unlisted Securities Upon Exchanges on January 3, 1936.
Securities and Exchange Commission, REPORT ON TRADING IN UNLISTED SECURITIES UPON EXCHANGES
(January 3, 1936) (“1936 Report”). The 1936 Report recommended that unlisted trading be continued as
long as it satisfied certain conditions, and the amendments of 1936 codified UTP.

155

See, e.g., Stock Exchange Practices Report of the Senate Committee on Banking and Currency Pursuant to
S.Res. 84 (72d Congress) and S.Res. 56 and S.Res. 97 (73d Congress), S. REP. NO. 1455, 74 (June 16,
1934) (explaining the concerns raised by unlisted securities). At the time, the unlisted securities category
of primary concern was “solely traded” securities that were traded on an exchange, but were not listed on
any exchange. These “solely traded” securities were not required to comply with the extensive financial
information and regulatory disclosure requirements to which dually traded securities (i.e., securities listed
on one exchange but permitted to trade on another exchange) were subject. See id. at 69.

156

See id. at 3 (“If tomorrow, for example, unlisted trading should be abolished and the requirement should be
made that all securities should be required to register, the result would be that many small exchanges would
be forced to close.”).

21

trading of unlisted securities and Congress’s enactment of the 1936 amendments to Section 12(f)
to allow for UTP.157 Concern about intermarket competition, given the market dominance of
first the NYSE and later both the NYSE and Nasdaq, also largely informed the subsequent
legislative and Commission approaches to UTP through the early 2000s.158 Since the approval
of Regulation NMS in 2005, however, there has been a proliferation of trading across multiple
trading venues, which has contributed to fragmentation and related concerns regarding market
quality and liquidity for thinly traded securities.159
B.

Regulation NMS and Other Exchange Act Rules

The Commission Statement notes that some market structure innovations may require
exemptive relief from certain Regulation NMS or other Exchange Act rules. The Exchange Act
establishes a statutory scheme for the trading of securities. In particular, the 1975 amendments
to the Exchange Act enacted Section 11A, which sets forth the five objectives of the U.S.
national market system: (1) economically efficient execution of securities transactions; (2) fair
competition among brokers and dealers, among exchange markets, and between exchange
markets and markets other than exchange markets; (3) the availability to brokers, dealers, and
investors of information with respect to quotations for and transactions in securities; (4) the
practicability of brokers executing investors’ orders in the best market; and (5) an opportunity,
consistent with (1) and (4) above, for investors’ orders to be executed without the participation of
the dealer.160 Subsequently, in 2005, the Commission adopted Regulation NMS, which in large
part established new substantive rules designed to modernize the national market system, such as
the Order Protection Rule, as well as modernized and incorporated existing national market
system rules, such as those addressing quoting obligations.161

157

The Commission’s recommendation in the 1936 Report was “an endeavor to create a fair field of
competition among exchanges and between exchanges as a group and the over-the-counter markets and to
allow each type of market to develop in accordance with its natural genius and consistently with the public
interest.” H.R. REP. NO. 2601, 74th Cong., 2d Sess. 4 (1936). See also Tom Arnold, Philip Hersch, J.
Harold Mulherin & Jeffry Netter, Merging Markets, 54 J. FIN. 1093 (1999) (providing a detailed history on
the changes impacting regional exchanges in the early to mid-twentieth century and the impact of midtwentieth century regional stock exchange mergers).

158

The Unlisted Trading Privileges Act of 1994 removed the application, notice, and Commission approval
process from Section 12(f) to expedite the process for exchanges to extend UTP. Pub. L. No. 103-389, 108
Stat. 4081 (1994). At the time, Congress viewed eliminating such rules as consistent with its general policy
of “always seeking to increase competition.” See Hearing Before the Subcommittee on
Telecommunications and Finance of the House of Representatives Committee on Energy and Commerce on
HR 4535, 103rd Cong., 2d Sess. (June 22, 1994), at 20-21.

159

Currently, there are 13 national securities exchanges trading equities. There has been one additional
equities exchange that has been approved by the Commission but that has not commenced trading. See
Securities Exchange Act Release No. 85828 (May 10, 2019), 84 FR 21841 (May 15, 2019) (order
approving the Long Term Stock Exchange, Inc. as a national securities exchange). The number of national
securities exchanges trading is subject to change.

160

See 15 U.S.C. 78k-1(a)(1)(C).

161

The Order Protection Rule requires trading centers to establish, maintain, and enforce written policies and
procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations

22

When the Commission adopted Regulation NMS, it sought to balance competition among
markets and competition among orders,162 explaining that in its marketwide approach it was
aiming to avoid the two extremes of, on the one hand, “isolated markets that trade an NMS stock
without regard to trading in other markets and thereby fragment the competition among buyers
and sellers in that stock,” and, on the other hand, a “totally centralized system that loses the
benefits of vigorous competition and innovation among individual markets.”163 The Commission
highlighted, among other things, the drawbacks of insufficient competition among orders,
including lower quality of price discovery, which could in turn reduce market depth and liquidity
and create excessive short term volatility. The Commission also highlighted the importance of
promoting deep and stable markets that minimize investor costs.164
IV.

Conclusion

This staff paper provides information on the market structure related to thinly traded
securities, including the unique trading challenges and characteristics related to thinly traded
securities. It is intended to provide some background context as market participants consider the
Commission Statement. The staff looks forward to any proposals that may be submitted in
response to the Commission Statement.

displayed by other trading centers, subject to an applicable exception. See 17 CFR 242.611. See also
Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) (adopting
Regulation NMS) (“NMS Release”). Rule 602 under Regulation NMS outlines the requirements for
disseminating quotations in NMS securities. See 17 CFR 242.602.
162

See NMS Release, supra note 161, 70 FR at 37499.

163

Id. at 37498-99.

164

See id.

23

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Asec%3Af83f95f0c0cfda94. Public record. Not legal advice.