The Effects of Decimalization
on the Securities Markets
By: Laura S. Unger
Acting Chair, U.S. Securities & Exchange Commission
Before the Subcommittee on Securities and Investment
Committee on Banking, Housing, and Urban Affairs
United States Senate
May 24, 2001
Chairman Enzi, Ranking Member Dodd, and Members of the Subcommittee:
I am pleased to testify today on behalf of the Securities and Exchange Commission ("Commission" or "SEC") concerning the recent conversion of quotations in equity securities and options from fractional to decimal pricing and the effects that this change has had on market dynamics and trading behavior. I would particularly like to address not only the benefits of decimalization, but also some aspects of this historic change that could affect the transparency, liquidity, and fairness of our markets.
As you know, under Congress' leadership, over the past year the U.S. markets have 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 viewed as necessary to simplify pricing for investors and to make our markets more competitive internationally. Many proponents of decimalization also hoped that decimal prices would ultimately reduce trading costs for investors by, among other things, permitting quotation spreads (the difference between the highest bid quotation and the lowest offer quotation) to narrow from the 1/16th minimum increment that was standard in the fractional environment.
Over the last year, the Commission has sought to ensure that the conversion to decimal pricing was accomplished in as rapid but orderly a manner as possible. On June 8, 2000, we issued an order directing the securities exchanges and the Nasdaq Stock Market ("Nasdaq") to phase-in decimal pricing beginning no later than September 5, 2000, and ending no later than April 9, 2001.1 As a result of the careful planning, preparation, and coordination among regulators, the markets, clearing agencies, vendors, and the securities industry, I am able to report that the phasing-in of decimal pricing was completed on schedule and without significant operational problems or trading disruptions.
While comprehensive analyses of the market effects of decimalization are not yet available, preliminary reviews by the Commission's Office of Economic Analysis ("OEA") and Nasdaq indicate that at least some of the anticipated benefits of decimalization, such as the significant narrowing of quotation spreads, are already evident. For example, OEA estimates that, from December 2000 to March 2001, quotation spreads in securities listed on the New York Stock Exchange ("NYSE") narrowed an average of 37%, and effective spreads narrowed 15%.2 An even more dramatic reduction in quotation spreads was observed in Nasdaq securities, with spreads narrowing an average of 50% following decimalization, and effective spreads narrowing almost as much. While it is difficult, at this time, to formulate accurate estimates of the extent to which investors may have benefited from decimalization, the overall narrowing of spreads makes it likely that investors entering small orders that are executed at or within the quotes have experienced 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.
Nevertheless, the Commission has long recognized that the shift from fractional to decimal prices had the potential to influence market dynamics and trading behavior in ways that could affect the transparency, liquidity, and fairness of the markets. When ordering the decimal conversion last June, therefore, the Commission required the markets to carefully phase-in this process in order to provide regulators and market participants opportunities to observe how decimalization worked in practice. The Commission hosted a roundtable on December 11, 2000 to solicit viewpoints on how the early phases of decimalization were affecting markets and trading. Moreover, our June 8, 2000 decimals order required the markets to conduct their own studies within a few months of the full implementation of decimal pricing on April 9, 2001 that would analyze how the conversion had affected systems capacity, liquidity, and trading behavior. In view of the complexity of some of the issues that have been raised concerning decimal pricing, the Commission has extended the deadline for the markets' studies to September 10, 2001.3 In the meantime, we are continuing to work with the markets and market participants to identify any aspects of decimalization that might compromise the fair and orderly operation of the securities markets.
Today, I would like to focus on how decimalization has affected market transparency and liquidity, as well as key investor protection and market integrity rules of the Commission and the self-regulatory organizations ("SROs").
II. EFFECTS ON MARKET TRANSPARENCY AND LIQUIDITY
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, OEA has estimated that 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.4 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.5
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.
III. INVESTOR PROTECTION AND MARKET INTEGRITY
We recognize that decimal pricing also raises a number of issues regarding vital investor protection and market integrity rules of the Commission and the SROs that depend on price changes or differentials. I'll briefly mention two examples.
Customer Limit Order Protection Rules
Investors use two main types of orders to buy securities: market orders and limit orders. When a customer uses a market order, a broker will execute the order in the market at the best price available. When a customer uses a limit order, a broker is required to obtain an execution at the limit price or better. By submitting a limit order, the customer competes for a better price than the market is offering, or limits the price that the investor will accept. As a result, limit orders provide liquidity to those who demand immediate execution. 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.6 However, specialists and market makers can "step ahead" of customer limit orders by trading at a price better than the existing limit order.7
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 which is greater than the limit order by at least the minimum quoting increment.8 However, with the conversion to decimals, the minimum price 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.9 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. In addition, the NYSE held a meeting on February 16, 2001 with a cross-section of market participants to discuss several issues related to decimal trading - including "stepping ahead." The NYSE reported after the meeting that while it believed that some of the problems associated with decimals may be behaviorally solved, some other issues might need to be addressed systemically, and has organized committees to examine these issues and develop possible solutions.
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
A short sale is the sale of a security that the seller does not own or that the seller owns but does not deliver.10 In general, short selling is utilized to profit from an expected downward price movement, or to hedge the risk of a long position in the same security or in a related security.
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.11 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.12
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.13 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. 14
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 1999,15 the Commission's staff is gathering data and is considering rule changes to address short selling in a decimals environment.
IV. SUBPENNY TRADING
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 ("ECNs") 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 four to six percent 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.16 As noted earlier, 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.17 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 (so-called "trading ahead"). 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 (inside) 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.
Because subpennies increase the concerns raised by decimal trading, the Commission needs to consider the impact of subpenny trading on market transparency and liquidity, as well as investor protection and market integrity rules.
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. I want to assure you that the Commission is working with the markets and the securities industry to address potential problems while preserving the benefits of decimalization. We appreciate the Subcommittee's continuing interest in this issue and the role it has played in helping to ensure a smooth transition to decimals.
1 See Securities Exchange Act Release No. 42914 (June 8, 2000), 65 FR 38010 (June 19, 2000).
2 The effective spread measures the cost of trading by comparing the execution price of a trade with the current mid-point of the quoted spread. Since trades sometimes occur at prices that are better than the posted quotes, the effective spread measure captures this "improved pricing."
3 The difficulties inherent in conducting useful analyses of the effects of decimalization in such a short time frame were also discussed in a letter from the American Stock Exchange ("Amex") requesting an extension of the June 8, 2001 deadline for decimalization studies. See letter to Annette Nazareth, Director, Division of Market Regulation, from Peter Quick, Amex President, dated May 9, 2001. The Commission has decided to extend the study deadline not only for the Amex, but also for the other securities exchanges and the NASD.
4 See letter to Richard A. Grasso, Chairman, New York Stock Exchange, Inc., from Craig S. Tyle, General Counsel, Investment Company Institute, dated March 1, 2001.
5 See Securities Exchange Act Release No. 44084 (March 16, 2001), 66 FR 16307 (March 23, 2001) (NYSE Rule 60). The Commission's Advisory Committee on Market Information is also considering a range of market transparency issues.
6 Exchange Act Rule 11a1-1(T) requires exchange members to grant priority to any bid or offer at the same price for the account of a person who is not a member. NYSE Rule 92(b) prohibits NYSE members from trading for their own account at the same price as an unexecuted customer limit order. The NASD's Manning Rule similarly requires the execution of a customer limit order upon the execution of a proprietary trade at a price that would satisfy the customer limit order. See NASD IM-2110-2- Trading Ahead of Customer Limit Order.
7 It should be noted that when a specialist or market maker "steps ahead" of a limit order, it provides "price improvement" to the execution on the contra side of the trade. For example, assume that a customer limit order is sent to a specialist or market maker to buy 100 shares of XYZ stock at $10 per share for a total of $1,000. The specialist or market maker may decide to "step-ahead" of the customer limit order and trade with a customer order to sell the security. While the customer buy order would remain unfilled in this situation, the customer sell order would receive a price from the specialist or market maker that is better than it would have received from an execution with the customer buy order.
8 NYSE Rule 92(b) establishes a de facto "stepping-ahead" increment based on the NYSE's minimum trading and quoting increment. That increment is currently a penny for most securities. The NASD's Manning Interpretation requires market makers who want to trade ahead of customer limit orders to trade at a price $0.01 better than the customer limit order priced at or better than the inside market. For customer limit orders priced outside the inside market, a market maker must trade at a price at least equal to the next superior minimum quotation increment. See Securities Exchange Act Release No. 44165 (April 6, 2001) 66 FR 19268 (order approving Nasdaq proposed rule change to the Manning Interpretation adopting a $0.01 price improvement standard for securities quoting in decimals.)
9 For example, assume that a public limit order is entered to buy 100 shares of XYZ stock at $10 per share for a total of $1,000. Under fractions, with a minimum price increment of 1/16th a specialist or market maker could trade ahead of the customer buy order by executing at $10 - 1/16th per share, for a total of $1,006.25. With the decimals minimum price increment of a penny, it is possible that the specialist or market maker could "step-ahead" of the customer order by paying $10.01 per share for a total cost of $1,001 to buy 100 shares, an 84% reduction in the "stepping-ahead" cost.
10 See Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3.
11 17 CFR 240.10a-1
12 NASD Rule 3350 prohibits short sales by NASD members in NMS securities at or below the current best (inside) bid as shown on the Nasdaq screen when that bid is lower than the previous best (inside) bid (commonly referred to as the "bid test"). Rule 3350 contains certain exemptions, including an exemption for qualified Nasdaq market makers, options market makers, and warrant market makers. The Rule also contains exceptions similar to those provided under Rule 10a-1.
13 See Securities Exchange Release No. 44030 (March 2, 2001) 66 FR 14235 (March 9, 2001).
14 The Nasdaq study is due on December 1, 2001.
15 Securities Exchange Release No. 42037 (October 20, 1999) 64 FR 57996 (October 28, 1999).
16 Securities Exchange Act Release No. 44165 (April 6, 2001), 66 FR 19268. The Commission also approved on April 6, 2001, a pilot program setting forth protections that must be provided by specialists and market makers on the Chicago Stock Exchange ("CHX") for customer subpenny orders in Nasdaq securities. Securities Exchange Act Release No. 44164 (April 6, 2001), 66 FR 19263 (April 13, 2001). The Nasdaq and CHX proposals were approved as pilot programs until July 9, 2001, during which time the markets will supply the Commission staff with monthly reports on their activity in subpenny increments.
17 See text at n. 6, above; NASD IM-3220-2- Trading Ahead of Customer Limit Order.