By Scott Kupor
FORTUNE -- As Americans, we love efficiency. In huge numbers, and with our wallets wide open, we rush toward anything that drives lower cost, highly liquid markets. Think about it. McDonald's, Amazon and Costco dominate their industries with some combination of huge choice, overall lower prices and massive volume.
At scale, efficient markets can be great. Consumers get more for less, and producers profit from the combination of high volume at low cost. And efficiency begets even more efficiency – producers re-invest their profits to develop new products and to continue to lower production costs while consumer choice expands.
But sometimes the drive for efficiency goes too far. Particularly when that efficiency leads to complexity and hidden costs.
Such is the case with the trading market for small cap stocks – shares of companies with a market value of less than $750 million. The proverbial dog has caught the efficiency bus, only to find the wheels are falling off. The small cap market needs less efficiency – about a nickel's worth – and more simplicity along with it. Without it, the market that has historically created jobs, developed break-through technologies and rewarded investors with stock price appreciation will seize up for good.
Before we get to that nickel, how did we get here?
A series of changes in the US equities markets since the mid-1990's – electronic trading, order handling, pricing and trading rules, and decimalization – have in fact led to lower transactions costs for investors.
As a result, the US equities market as a whole is a highly efficient, liquid market.
Look no further than the rise of high frequency trading and other algorithm-based strategies that account for as much as 70% of total trading volume. These strategies make complete sense in a liquid market. Where you have low transaction costs and sub-penny spreads, traders can still earn profits with rapid, high-volume trading.
But not all stocks are created equally. While large cap stocks benefit from an environment that supports their trading liquidity – notably, broad research coverage from analysts and investment banks, and sales desks that facilitate large trades with market-making institutional investors – many small cap stocks are practically invisible.
As the march toward efficiency has increased complexity and shrunk margins to sub-penny increments, all of these liquidity-enhancing resources have been re-directed to high volume, large cap trading opportunities. Even more importantly, the mutual find industry, which manages $5.2 trillion of investments in equities on behalf of individual investors, has all but abandoned the small cap universe due to the complexity and fragmentation of the current market structure.
As a result, the small cap trading market is anything but liquid. Consider:
Why is putting liquidity back into the small cap market vitally important? Simply put, it's because jobs hang in the balance.
Until the last decade, about 300 start-up companies went public each year, with more than half of those companies being small cap IPOs. Fast-forward to the most recent decade, and fewer than 100 companies each year have gone public, with less than one-third of those being small cap IPOs.
According to the Kauffman Foundation, small caps increase their post-IPO hiring by 156%. As a result, the small cap IPO doldrums have cost us an estimated 1.9 million new jobs.
In addition to jobs, illiquidity in the small cap market is costing retail investors real money. Because institutional investors won't play in an illiquid market, individuals – who comprise 73% of the shareholder base of small caps – end up holding the bag. Illiquid stocks are less likely to be able to raise additional capital in the public market or use their stock as currency to fund acquisitions, compensate employees and compete for talent. This in turn hampers growth, ultimately resulting in less stock price appreciation to the individual retail investor.
Increasing liquidity in small cap stocks not only would help the 73% of individual shareholders who are already in the market but, more significantly, it also would open up the market to broader mutual fund investment.
About 90% of mutual funds assets are owned by nearly half of American households, representing nearly one-quarter of all U.S. household wealth. Making the small cap market accessible to mutual funds today would open up a whole new opportunity for retirement asset appreciation for the 58 million US households who invest in mutual funds.
Which gets us back to that nickel, and how a little inefficiency could have a huge impact.
As part of the JOBS Act (passed last year), the SEC was asked to study the effects of decimalization on liquidity in the small cap market. To date, the SEC has held a series of public hearings on the topic but has not implemented any formal changes to the capital markets.
As co-chair of the Equity Capital Formation Task Force, I am calling on the SEC to implement a multi-year pilot program designed to demonstrate that increasing the trading increments for small cap stocks from $0.01 to $0.05 will, in fact, increase trading liquidity in these markets -- thus driving higher volumes of small cap IPOs, growing jobs and creating attractive investment opportunities for 58 million households.
No doubt market efficiency is a laudable goal, but not at the expense of simplicity, and not if it means the collapse of a market that holds the key to sustained U.S. job growth, economic development and technology breakthroughs.
Scott Kupor is the managing partner at Andreessen Horowitz, where he is responsible for all aspects of running the firm. Previously, he was VP/GM of Global Customer Support & Software-as-a-Service at Hewlett Packard. Follow Scott on Twitter, @skupor.
The SEC issues rules on equity crowdfunding. What took it so long?
FORTUNE -- The current Securities and Exchange Commission chair has the same first name as her predecessor. But one clear difference between Mary Jo White (new) and Mary Schapiro (old) is that the former actually cares about doing her job.
Today the SEC formally proposed rules on equity crowdfunding, a mechanism through which private companies would be able to raise small MOREDan Primack - Oct 23, 2013 1:52 PM ET
ff Venture Capital is asking for money. Publicly.
FORTUNE -- This morning ff Venture Capital will become the first VC firm to take advantage of the SEC's new general solicitation rules, which allow companies and investment firms to publicly seek capital from accredited investors.
The New York-based firm focuses on seed and early-stage companies that "deploy lightweight disruptive business models to become the low-cost player in their respective market." Its biggest hit MOREDan Primack - Oct 11, 2013 7:46 AM ET
The SEC today voted to let hedge funds and others "generally solicit." What does that mean?
FORTUNE -- The Securities and Exchange Commission today voted 4-1 to end a decades-old ban on "general solicitation" by many private issuers, including hedge funds, private equity funds and start-up companies.
The recommendation to do so first appeared in the JOBS Act, a piece of bi-partisan capital markets legislation that became law in March 2012.
In short, MOREDan Primack - Jul 10, 2013 11:24 AM ET
General solicitation is coming, and that means big things for SecondMarket.
FORTUNE -- The Securities & Exchange Commission this morning will vote on a proposed rule that would permit general solicitation by private-market issuers, including private equity funds. And if they approve the rule, expect SecondMarket to flip the switch on a stealthy new general solicitation platform that would include investor accreditation verification solutions.
For the uninitiated, private equity funds currently are not MOREDan Primack - Jul 10, 2013 10:17 AM ET
When hedge fund managers advertise, performance dips.
FORTUNE -- Hedge funds soon will be allowed to advertise their wares to potential clients, thanks to a provision in last year's JOBS Act (which had no direct relation to actual jobs). As will private equity funds, venture capital funds and other alternative investment vehicles that heretofore were prohibited from general solicitation.
Former SEC Commissioner Mary Shapiro opposed the change, so she basically sat on MOREDan Primack - May 23, 2013 3:29 PM ET
The part of Steve Rattner's JOBS act column that hasn't gotten enough attention.
FORTUNE -- Steve Rattner has been taking some heat for a recent New York Times column that was deeply critical of the JOBS Act. I actually applaud his willingness to take on this sacred cow, although my own take on the legislation is more ambivalent.
Most of the attention has been focused on Rattner's choice to equate crowd-funding with MOREDan Primack - Mar 5, 2013 5:06 PM ET
Startup crowdfunding is due to change drastically this year. Here's advice from Ronny Conway, Ben Horowitz, Kevin Rose, and others.
By Kurt Wagner, reporter
FORTUNE -- Investing successfully in startups takes more than a pocketful of cash. That's the message venture capitalists and securities regulators hope to transmit to those interested in equity-based crowdfunding, a new form of investing currently awaiting regulatory approval. Ordinary investors will soon have the opportunity to invest MOREFeb 25, 2013 10:30 AM ET
Mary Schapiro's job not well done.
FORTUNE -- We may now know why the SEC has been taking so long to finalize private placement marketing rules, as it was directed to do by this past spring's JOBS Act. From Reuters:
"Outgoing U.S. Securities and Exchange Commission Chairman Mary Schapiro delayed immediately implementing a rule to lift a ban on broader-based advertising for private placements in part because she feared it would tarnish MOREDan Primack - Dec 3, 2012 1:02 PM ET
* Boom: SEC's Schapiro delayed JOBS Act to protect legacy
* Chris Dixon: Product lens vs. finance lens for startups
* Carlyle's Jason Thomas: Is the fiscal cliff dive already baked in?
* Morning Call: U.S. futures point higher, European shares climb and the Nikkei rises.
* Rob Go: Super angels, two years later
* No Renesas for you: KKR can't penetrate Japan's deal club
* Julie Bort: Meg Whitman's blame game may be backfiring
* Get Term Sheet: MOREDan Primack - Dec 3, 2012 7:03 AM ET
|Michaels hack hit 3 million|
|Wealthy investors flock to fine art funds|
|GM's recalled Cobalt was a failure from the start|
|Obama would cut deficits by another $1 trillion|
|Judge won't force GM owners to 'park' cars|