Speech by SEC Staff:
Regulatory and Compliance Issues in a Decimalized Environment
by Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities & Exchange Commission
Securities Industry Association Legal Compliance Committee
June 8, 2001
Good morning. It is a pleasure to be here today. As usual, before I start, I am required to point out that these comments represent my views -- they may not represent the views of the Commission or my colleagues on the staff. 1
My topic today is the intertwined regulatory and compliance issues raised by trading equity securities in penny and even subpenny increments. Regulators, self-regulators, and the industry - as well as the Congress, are currently striving to analyze how the shift to decimal pricing is affecting a wide range of vital investor protection and market structure issues. Thanks to the industry's hard work in the planning and testing phases, the decimal conversion did not result in any widespread systems or capacity problems. But to a great degree, our real work has just begun. And I must stress that your input on the critical regulatory and compliance issues that we face will be essential.
The Changing Environment
Over the past year the U.S. markets have successfully moved from pricing shares in fractions to pricing shares in dollars and cents - the same pricing used in virtually all other aspects of the economy. The goal of decimalization was to simplify pricing for investors and to make our markets more competitive internationally. Decimalization was also expected to ultimately reduce trading costs for investors by narrowing quotation spreads - that is, the difference between the highest bid quotation and the lowest offer quotation -- from the 1/16th minimum increment (or 6.25 cents) that was standard in the fractional environment to a penny.
While comprehensive analyses of the market effects of decimalization are not yet available, I am pleased to report that preliminary reviews by the Commission and the markets indicate that these goals have been largely met. For example, quotation spreads in NYSE securities narrowed an average of 37%, and effective spreads -- that is, a more accurate measure of trading costs that takes into account trades within the quote spreads -- narrowed 15%. An even more dramatic reduction in quotation spreads was observed in Nasdaq securities, with spreads narrowing an average of 50%, and effective spreads narrowing about the same. While it is difficult to estimate the overall cost savings to investors, the narrowing of spreads makes it likely that investors entering small orders that are executed at or within the quotes are indeed experiencing reduced trading costs.
In addition, preliminary studies by Nasdaq indicate that, despite the concerns previously raised by some market commentators, decimal pricing has not expanded quotation traffic or exacerbated capacity demands to the extent anticipated. Although there is some evidence that the number of quotation updates has increased, the fears that decimalized quotes would cause reporting backlogs and outages appear to have been unfounded to date.
Nevertheless, as the Commission has long recognized, the shift from fractional to decimal prices has begun to influence market dynamics and trading behavior in fundamental ways. For example, penny increments have substantial implications for the broker-dealer community from both compliance and business perspectives. How are long-established customer protection and market integrity rules and policies satisfied when quotes are flickering in tiny price increments? And what are the implications of the shifts to commission-based fees in OTC stocks that are being brought about by narrowing quote spreads and the resulting reduction in profits? Frankly, we are encouraged by the latter development, as clearly disclosed commissions may prove helpful to investors by giving them a better idea of true trading costs. Similarly, reduced trading profits will substantially reduce the profits available to pay for order flow.
It's because the move to decimals has begun to change market behavior in fundamental ways that we decided to give the markets more time to submit their studies to the Commission analyzing how the conversion has affected systems capacity, liquidity, and trading behavior. These reports are now due by September 10, 2001.
Today, I'd like to focus on the impact of quoting in penny increments, as well as the fairly infrequent practice of trading in subpenny increments, on market-wide transparency, liquidity, and investor protection rules.
Effects on Transparency, Liquidity, and Investor Protection
Market transparency -- the dissemination of meaningful quote and trade information -- assists investors in making informed order entry decisions and enables broker-dealers to meet their best execution duties for their customer orders. Moreover, market transparency plays an essential role in linking dispersed markets and improving the price discovery, fairness, competitiveness, and attractiveness of U.S markets. Currently, the quotes and trade reports from all registered exchanges and Nasdaq are published on a consolidated basis to vendors, brokers, and customers worldwide.
Decimal pricing presumably has enhanced the ability of investors to understand the consolidated quotations of competing market centers. Investors can now easily compare prices to buy and sell stocks in dollars and cents without having to deal with prices in fractions. Nevertheless, we recognize that, as the minimum quoting increment has narrowed to a penny, the market depth at any particular price level (that is, the number of shares available at the published bid or offer) has decreased as well. For example, quote sizes in NYSE-listed securities have been reduced an average of 60% since the conversion to decimals and preliminary analyses of Nasdaq securities show a 68% reduction in quote sizes. Some firms and institutional investors also have expressed concerns that the reduction in quoted market depth may be adversely affecting their ability to execute large orders. In particular, market participants have indicated that smaller trading and quoting increments have increased the risk of displaying limit orders, particularly larger limit orders, leading to a reduction in the amount of liquidity provided by such orders. In an effort to provide more information about available liquidity, the NYSE recently proposed, and the Commission approved on an accelerated basis, a rule to disseminate "depth indications" and "depth conditions" to reflect market interest in a security below the published bid and above the published offer. Initially, the NYSE changes provide market participants with indicators to show that there are at least 20,000 shares available within 15 cents of the bid or offer. In the meantime, the NYSE is developing the capability to show market participants the actual sizes of buy and sell interest around the inside quotes.
We recognize, however, that these measures alone are unlikely to address market participants' liquidity concerns in a decimal environment. We have asked the markets to evaluate these concerns in their reports to the Commission, and we will work with the markets and the securities industry to identify and address any negative effects from decimalization on overall market transparency and liquidity.
Customer Limit Order Protection Rules
We also need to determine if the customer limit order protection rules are adequate to meet the challenges of today's trading environment. As I noted earlier, limit order protections not only serve the interests of those investors entering the orders, but also benefit the markets as a whole. We must be cognizant that limit orders are a very important source of price information and market liquidity in the equity markets.
When customers submit limit orders, they are held by a specialist or market maker until the orders are executed, they expire, or are cancelled. Because they collect these limit orders submitted by customers, specialists and market makers may obtain informational and trading advantages. Commission and SRO rules protect customer limit orders by providing them with priority over specialist and market maker proprietary orders at the same price on the exchanges and on Nasdaq. However, specialists and market makers can "step ahead" of customer limit orders by trading at a price better than the existing limit order.
With some variations, the rules of the NYSE and the NASD require that a specialist or market maker who wants to "step ahead" of a customer limit order pay a price that is greater than the limit order by at least the minimum quoting increment. However, with the conversion to decimals, the minimum quote increment has decreased from one-sixteenth, or 6.25 cents, to one cent. This means that it could be less costly for specialists, market makers, and possibly certain other market participants to profit from their knowledge of limit order flow by trading ahead of limit orders for only a penny a share. Public traders may defend themselves from such stepping ahead practices by using floor brokers to hide their orders, by breaking up their orders, and by switching to market order strategies from limit order strategies. These responses could increase transaction costs and reduce market transparency.
Since the commencement of decimals trading, numerous articles have appeared in the press that have raised concerns about increased stepping ahead activity. Earlier this week, the NYSE announced that its market performance committee voted to bar specialists from breaking up clean crosses. When there is an exact match in order size between buyers and a sellers brought to the floor, a specialist will be prohibited from breaking up the cross by trading for his proprietary account even if this would offer some price improvement for one side of the cross.
The Commission currently is gathering information about the operation of these investor protection rules in the decimal environment, and will consider whether action is necessary to protect investors.
Short Sale Regulation
As you know, Commission Rule 10a-1 is designed to restrict short selling in a declining market. The rule applies to short sales in any security registered on a national securities exchange, and uses a "tick test", which means that a short sale generally must be at a price higher than the last reported sale for the security. The NASD also has a short sale rule for Nasdaq securities that requires a short sale to be effected at a price above the current bid in a declining market.
In a decimals environment, where price differences between trades can be a penny or less, the question is: how much above the last sale or the bid must a short sale be?
On March 2, 2001, the Commission took a step toward answering this question when we approved a change to the NASD short sale rule providing that a "legal" short sale must be executed at a price at least $0.01 above the current best bid. In approving this amendment on a one-year pilot basis, we noted that transactions based on very small price changes could undermine the operation of the short sale rules. While permitting a $0.01 increment standard for short sales during the initial stages of the conversion to decimal pricing, we required Nasdaq to submit a study analyzing the operation of the amended rule.
Essentially the same question arises in the context of the Commission's short sale rule. In addition to our ongoing review of the short sale rule, which was begun in our concept release in October 1999, the Commission's staff is gathering data and is considering rule changes to address short selling in a decimals environment.
Many of the regulatory issues that have arisen in a decimal environment may be exacerbated by the practice of trading at increments finer than $0.01, commonly referred to as subpenny trading. For years, some electronic communication networks and Nasdaq market makers have permitted trading in increments smaller than that displayed through the Nasdaq system. This practice has continued in the decimal environment, with approximately 4% to 6% of trades in Nasdaq securities executed in subpenny increments even though the quotations for these securities are at a penny increment.
On April 6, 2001, the Commission approved, on a pilot basis, a rule filed by the NASD specifying the protections Nasdaq market makers must provide to customer limit orders priced in subpennies. The NASD's Manning Interpretation requires the execution of a customer limit order held by a market maker if the market maker trades for its own account at a price that would satisfy the customer limit order. The market maker, however, can trade for its own account at a price better than the customer limit order and is not obligated to execute the limit order - the so-called "trading or stepping ahead" that I discussed earlier. The amendment to the Interpretation requires market makers who want to trade ahead of customer limit orders to trade at a price at least $0.01 better than the customer limit order priced at or better than the best displayed inside market. For customer limit orders priced outside the best displayed inside market, a market maker must trade at a price at least equal to the next superior minimum quotation increment.
These interim measures taken by the Commission over the past few months were needed so that existing customer limit order protection rules remain workable in a decimalized environment. Nevertheless, we recognize that subpennies may increase the concerns raised by decimal trading. In particular, we have serious concerns whether the miniscule potential for price improvement offered by subpenny trading justifies the potential for investor confusion and the possible impairment of key investor protection and market integrity rules.
Broker-Dealer Compliance and Business Implications
Finally, as I indicated earlier, the Commission recognizes that penny and subpenny trading have substantial implications for the broker-dealer community. For example, how will firms meet their best execution duties for customer orders in an environment of rapidly changing quotes from various market centers and market makers? How do firms meet their best execution obligations when using ECNs or related order-routing mechanisms that use subpenny pricing increments? Should regulators and self-regulators revaluate long-established customer protection and market integrity rules and policies that were designed for fractional prices?
In addition, we intend to keep abreast of the business implications from narrower quote spreads and reduced trading profits at firms. We will seek to accommodate the apparent desire by some firms to shift to an agency basis for handling large customer orders in OTC stocks. And we will examine the impact that reduced trading profits have on payment for order flow arrangements. I suspect that the reduced trading profits brought about by decimalization combined with the transparency of execution quality brought about by our new Order Execution Quality Rules will significantly reduce payment for order flow practices, imparting the benefits of more efficient prices where they belong - in the hands of investors.
The conversion to decimals went smoothly from an operational standpoint, thanks to the planning and cooperation among regulators, self-regulators, and the industry. Decimal trading has raised issues that must be carefully considered to ensure our markets remain transparent, liquid, and fair. As other market challenges have arisen over time, the Commission has embraced these challenges, working to adapt regulatory structures in a manner that will affirm investor confidence and help to lead our markets into the future. We believe that the conversion to decimals fosters these goals by simplifying pricing and making our markets more competitive internationally. We recognize, however, that there are some aspects of the effects of decimalization that still need to be considered thoroughly. The Commission will continue to work with the markets and the securities industry to address potential problems while preserving the benefits of decimalization. Your input on these issues would be more than useful - it is essential.
|1 || The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.|