Michael T. Dorsey
Senior Vice President
General Counsel and Secretary
December 4, 2001
Via Electronic Mail and Federal Express
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
Re: File No. S7-14-01 - Comments on the Effects of Trading in Sub-pennies
Dear Mr. Katz:
Knight Trading Group, Inc. ("Knight") welcomes this opportunity to comment on the U.S. Securities and Exchange Commission's (the "Commission") concept release on the effects of trading and quoting in sub-penny increments.1 Knight appreciates the move to trading securities in penny increments has benefited the investing public by narrowing spreads and by bringing an enhanced clarity to the pricing of securities. Along with the benefits of trading in penny increments, problems have arisen that may be compounded by trading and quoting in sub-penny increments. These problems include diminishing liquidity, diminishing levels of price improvement, and reduced market transparency. We believe sub-penny quoting may interfere with the application of the Commission's order handling rules. Knight encourages the Commission to permit market participants to accept and trade orders in any increment. Knight, however, encourages the Commission to prohibit the posting of quotations in sub-penny increments except in limit instances.
Knight, headquartered in Jersey City, New Jersey, is the parent company of Knight Securities, L.P., Knight Capital Markets, Inc., Knight Financial Products, L.L.C., and Knight Securities International, Ltd. Knight's subsidiaries make markets in equity securities listed on Nasdaq, the OTC Bulletin Board, the New York Stock Exchange, American Stock Exchange, Nasdaq Europe and in options on individual equities, equity indices, fixed income instruments and certain commodities in the United States and Europe. The firm also maintains an asset management business for institutional investors and high net worth individuals through its Deephaven subsidiary. Knight's clients include the leading brokerage firms, and more than 1200 broker-dealers and 1000 institutional clients. Currently, the five-year-old company employs more than 1300 people worldwide.
While the full impact of the conversion to trading in decimals is unclear, preliminary evidence indicates that individual investors are benefiting from the narrowing of quoted spreads and the decline in effective spreads. Evidence exists that quoted spreads have fallen for all stocks by an average of 51%. The decline is most pronounced for the more active and lower price securities where these issues have experienced a 71% decline. Effective spreads also have fallen by an average of 46%. The narrowing of the spread and the decline of the effective quoted spreads have proven in the past to reduce the costs associated with trading for individual investors.
Despite the benefits produced by the transition to trading in decimals, evidence also exists that the conversion has produced some negative consequences. Initial research has found trading outside the spread has increased as a result of decimalization. This appears to be the product of a lack of depth at the inside due to the penny minimum price variation ("MPV"). This may also be caused by larger orders being more likely to get filled outside the spread. Displayed depth on Nasdaq has also declined and is approximately one-third of what it was before the transition to trading in decimals. The most highly active Nasdaq issues with the lowest spread and the highest price have experienced substantial declines in quoted size.
Similarly, the conversion to trading in decimals resulted in a substantial decline in the average number of market centers at the inside quote. The decline, however, varies by the type of issue. Since the aggregate quoted size declined more than the number of market centers, it appears the reduction in quoted size is a product of two factors: the decline in the number of market centers at the inside, and reductions in the average quoted size shown by any given market center. This problem also has resulted in diminished price improvement opportunities and for much smaller amounts.
A. Permitting quoting in sub-penny increments will not promote the fair and orderly functioning of the markets.
Knight believes permitting quoting in sub-penny increments will not promote the fair and orderly functioning of America's financial markets. Instituting four decimal place quoting will result in the creation of more than 10,000 price points per dollar in each security. This proliferation of price points, coupled with the likely explosion in the number of quote updates and the resultant stresses on market participant systems, could jeopardize America's capital markets.
While Knight appreciates the suggestions of certain industry participants that the Commission should permit sub-penny quotes, we disagree with this suggestion for several reasons. First, Knight believes quotes should only be in penny increments for most securities because of the anticipated increase in quote updates and the resulting strains placed on the systems of the market and its participants. Second, we see no legitimate reason why a market should be required to produce quotes in sub-penny increments except for the imposition of certain transaction fees. These fees include, but are not limited to, the fees charged by broker-dealers operating Electronic Communications Networks. Except for these limited instances, quoting securities in sub-penny increments will not promote the public interest and may actually lead to the less efficient operation and development of our capital markets.2 Third, Knight believes that for securities in which displaying quotes in sub-penny increments may facilitate more effective trading, such as in the case of OTC Bulletin Board securities and securities identified in the Pink Sheets, four decimal place quotes may be appropriate. Expanded pricing opportunities for these low-priced securities may facilitate the execution of trades in these securities, but trading quotes should be limited to four decimal places to enhance efficiency for these securities and the markets in general.
B. Posting all quotes in sub-penny increments will further undermine the value of the NBBO.
Knight believes requiring market participants to post quotes in sub-penny increments will substantially undermine the value of the national best bid and offer. The 1975 Amendments to the Securities Exchange Act of 1934, resulted in the creation of the consolidated stream of transaction reports and quotations that is now available to the public on a real-time basis. The best displayed quotations of each exchange, market makers and alternative trading systems that executes orders in listed equities and Nasdaq equities, are collected by a single processor. This processor then calculates a consolidated best bid and offer (the "consolidated BBO") and disseminates the information to market participants and the public. The BBO is currently disseminated in penny increments.
For many years, the consolidated BBO has been treated as sacrosanct. With the implementation of trading in decimals however, the value of the consolidated BBO has diminished greatly as an indication of where the real market exists. The consolidated BBO now reflects the lack of liquidity existing at the inside market that has resulted from the conversion to trading in penny increments. The consolidated BBO also may mislead the public with respect to the quality of order executions available among various market centers trading the same issues. For example, the quality of executions afforded investor market orders by various market centers may vary widely in relation to the consolidated BBO at the time of order receipt. The price at which the order was executed may also fail to reflect that greater liquidity was available at a competing market center. In a decimalized world, the consolidated BBO no longer represents the best price or destination for execution of customer orders. The consolidated BBO fails to reflect the opportunity for customer orders to receive enhanced liquidity at a competing market center that is increasingly important in a decimal trading environment where liquidity has substantially diminished. Knight fears that quoting in sub-penny increments will only exacerbate these problems and further diminish the value of the consolidated BBO.
C. The Commission should not permit the use of sub-penny quotations because they will interfere with best execution and unnecessarily complicate the administration of the order handling rules.
Proponents of sub-penny quoting claim the expansion of the number of price points will encourage competition, further narrow bid-ask spreads and decrease payment for order flow. They also claim that narrower spreads will ensure better prices for retail market orders. However, there is ample evidence from the conversion to trading in decimals that quoting in sub-penny increments will further reduce the use of limit orders, impair transparency and impede best execution.
Moreover, Knight believes permitting quoting in increments finer than a penny will unnecessarily complicate the administration of the order handling rules. Knight is very concerned that permitting quoting and trading in increments finer than a penny with a minimum price improvement increment of a penny will create a disincentive for investors to use limit orders. We believe that if permitted to post sub-penny quotations, day traders will use this discrepancy to take unfair advantage of market makers and their auto execution algorithms. This gaming of market maker auto execution algorithms will encourage market makers to refuse to accept limit orders because they will be required to provide limit order protection that could be substantially greater than the minimum price variation of $0.01 for these same securities. The resulting decline in the use of limit orders by market makers will further impair market transparency and liquidity.
D. Quoting in sub-penny increments would make the administration of the short sale rule unmanageable.
Adopted by the Commission in 1938 to prevent bear raids through piling on in a declining market, the short sale rule, Rule 10a-1, is of little import in a decimal trading environment. Adopted at a time when the securities markets had less trading volume and simpler trading strategies, the Short Sale Rule is ill-suited to the decimal trading environment of today. Since the adoption of the rule, trading in equities has increased dramatically in volume, velocity, complexity and now form. The value of the rule and the ability of market participants to comply with its spirit will be further complicated by permitting quotations in sub-penny increments.
Quoting in sub-penny increments would make the administration of the short sale rule virtually impossible. Knight believes that even modifying the rule so as to conform to a trading environment with sub-penny quotations may not be possible because of the potential difficulty in applying the tick test in a market with flickering quotes. Knight believes that in light of the changes in trading behavior evidences since the implementation of trading in decimals with a penny minimum price variation, the Commission should explore eliminating the Short Sale Rule.
In conclusion, Knight believes permitting quoting in sub-penny increments will not promote the fair and orderly functioning of the financial markets. We believe quoting and trading in sub-penny increments will lead to increased levels of spurious trading activity, diminishing liquidity, and diminishing levels of price improvement. Moreover, Knight believes quoting in sub-penny increments will substantially undermine the applicability of the order handling rules and will make the application of the short sale rule virtually impossible.
Knight appreciates the opportunity to share our comments with the Commission on the potential impact of quoting and trading securities in increments finer than a penny. Should you or your colleagues have any questions or concerns, please do not hesitate to contact me at (201) 557-6910.
Michael T. Dorsey
cc: Hon. Harvey Pitt
Hon. Laura Unger
Hon. Isaac C. Hunt, Jr.
Annette L. Nazareth
Robert L. D. Colby
|1||Exchange Act Release No. 44568 (July 23, 2001), 66 Fed. Reg. 38390 (July 24, 2001).|
|2||Knight believes that posting quotes in increments finer than two decimal places for all Nasdaq securities may further the efforts of day traders who provide little value to America's capital markets. These day traders may quote in increments finer than two decimal places to post prices that can be gamed for profit.|