[THE VIEW]Why Did the US SEC Reduce Stock Price Increments?

Regulation Changes from 1 Cent to 0.5 Cent
More Accurate Asset Valuation
Reduced Trading Costs with Smaller Price Increments

Recently, the U.S. Securities and Exchange Commission (SEC) passed a market regulation that changes the minimum price increment for certain stocks from the existing 1 cent to a smaller 0.5 cent. Earlier in early 2023, the Korea Exchange also reduced the minimum price increments for stocks in certain price ranges. Why are these minimum price increments being changed?

The ask price is set at or above the value sellers perceive, while the bid price is set at or below the value buyers perceive. Due to the asymmetry of information, which is central to asset valuation, a bid-ask spread occurs. The greater the information asymmetry, the wider the difference between the ask and bid prices. Additionally, the fewer the investors trading?that is, the lower the liquidity?the larger the bid-ask spread becomes.

Originally, stock markets had much greater information imbalances and limited means for market participation compared to today, so spreads were inevitably large. Brokers could profit by connecting buyers and sellers and capturing the difference in the spread.

Since the 1800s, the U.S. stock market mostly used price increments of 12.5 cents. This was because the U.S. initially referred to British currency units and used fractional units for convenience, quoting prices in eighths of a dollar. With a minimum price increment of 12.5 cents, the minimum bid-ask spread was also maintained at 12.5 cents for a long time. It was only in 1997 that the market switched to sixteenths of a dollar for more precise pricing, and in 2001, decimal pricing was introduced, setting the minimum increment at 1 cent as it is today. Now, the SEC plans to reduce this further to 0.5 cents.

So why keep reducing the minimum price increment? One reason is to evaluate asset values more accurately. Even if a stock’s value is $100.005, due to the limitation of price increments, trades occur at $100.01 or $100.00, making it difficult to judge the exact value based on transaction prices. Also, investors who repeatedly buy and sell pay costs equal to the spread, so stocks that had room for narrower spreads due to price increment restrictions can reduce trading costs by decreasing the minimum price increment.

The SEC initially considered reducing the minimum price increment to 0.1 cent but settled on 0.5 cent. If reducing the price increment only benefited investors, why not reduce it further? When the price increment shrinks and spreads narrow, the incentive for brokers who connect buyers and sellers?previously earning from the 1 cent spread?diminishes, reducing their activity in facilitating trades.

Therefore, liquidity may decrease, negatively affecting market vitality. Also, with more granular price increments, a wider variety of prices emerge, reducing price concentration. This can lead to increased volatility with each trade. Large block trades may also have a greater impact on prices, making them more challenging.

Seonggyu Park, Professor at Willamette University, USA