Bats may open doors for illiquid stocks by closing them

It is not often a new chief executive, just 10 days into his job, tells his customers to go and use a rival's product.

That is one interpretation of the email late on Thursday to staff and customers by Chris Concannon, chief executive of Bats Global Markets.

In it, he said Bats would soon propose that illiquid stocks with primary listings elsewhere (ie the New York Stock Exchange or Nasdaq) are no longer offered on the US's second-largest exchange operator.

Bats is not a venue for corporate listings and probably will not lose very much, if anything, since the shares are not traded very often. The proposal is being sent to the Securities and Exchange Commission (SEC) for approval, although exchanges are not mandated to offer trading in every stock.

The reasoning seems sound. As Mr Concannon noted, concentrating liquidity at a single venue would lead to easier price formation. That venue could also innovate their markets for illiquid stocks, via tick size and auctions. If and when it has grown up, then it can play in the big leagues and be offered on all exchanges.

It sounds small but begins to address a constituent of markets that are too often treated like some vague afterthought but on which the entire edifice depends: the companies that come to list, to raise money and grow. As Nasdaq chief executive Bob Greifeld noted, issuers seem to have been missed off the list of represented in the SEC's new Equity Market Structure Advisory Committee.

But with it Bats puts its finger on another thorny issue. "Most importantly, we are not advocating for a trade-at rule as part of this proposal as we believe it would be disruptive to the market," said Mr Concannon.

This will present a dilemma for the SEC. A "trade at" rule would require all trades to improve the price of the last trade and has been regularly discussed by the SEC after the May 2010 flash crash. In theory it could force internal broker crossing networks and dark pools to send their trades to public exchanges, unless they can execute the trades at a meaningfully better price than available on an exchange, making it more difficult for off-exchange venues to compete.

It's been highly criticised by brokers (unsurprisingly) but would be an easy populist win for an agency wanting to look as if it was being decisive in the wake of the furore surrounding the Michael Lewis book Flash Boys a year ago.

Yet the SEC has shown a strong reluctance to publicly back it, in part because of the difficulty of defining and showing "a better price". After all, the rules under which it must work - the Regulation National Market System - has enshrined investors get the best possible price, no matter where they trade.

Even so, the SEC is testing the water. Its pilot scheme of widening tick sizes in small-caps is aimed at improving their liquidity. One batch is also assessing the controversial "trade at" rule for 400 small-caps.

If the SEC deems the pilot successful, it would likely be rolled out across the market. There would also be calls for a "trade-at" rule to be rolled out et and lower the amount of trading done off-exchange.

Bats's proposal, when it arrives, will present the SEC with some interesting decisions. If the agency approves it, what does that mean for the SEC's own tick pilot programme for small-caps? Can the two really work in tandem? And it will have to decide when one of their market structure experts, Gregg Berman, is leaving. One can only sympathise. Faced with this complexity, who would be a regulator?

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