Speech by SEC Acting Chairman:
New Millennium, New Market
Acting Chairman Laura S. Unger
U.S. Securities & Exchange Commission
Before the Exchequer Club
July 18, 2001
Thank you for the kind introduction. I would like to use my time today to talk about decimals.
Right on the heels of the Y2K systems conversion, the U.S. markets moved in the last year from pricing shares in fractions to pricing shares in dollars and cents. The Commission had several goals in having the markets convert to decimal trading, including: (1) maintain our market's competitive position globally, (2) offer simplicity and clarity to retail investors, (3) increase competition among market participants, and finally, (4) bring about narrower quotation spreads – potentially reducing costs to investors.
While certainly not a simple task to accomplish given the panoply of legal and technical issues to be addressed, the markets successfully completed the conversion to decimal pricing on April 9, 2001. And it appears, at least preliminarily that the goals of decimalization have been largely met.
As you know, I am almost incapable of making remarks without mentioning how technology has affected our markets. Today, I would like to put decimals into the mix of technology and market structure. Over the last couple of years, technology has brought about significant changes to the market. The Commission has considered in a number of rulemakings how these changes impact the basic underpinnings of our markets, including such things as market transparency and liquidity, as well as key investor protection and market integrity rules. I would like to highlight some of these issues and then share with you my concerns about quoting and trading in subpennies – that is, in increments of less than one cent.
The Benefits of Decimals Trading
The biggest benefit of decimalization is quite apparent. As a result of converting to decimals, the minimum price variation ("MPV") for stock quotes went from 1/16th of a dollar to a penny. Preliminary reviews by the Commission's Office of Economic Analysis and by Nasdaq show that decimal trading has substantially narrowed quoted spreads. Nasdaq reports that the average effective spread for its securities has shrunk about 50 percent since decimalization went into effect. Similarly, our Office of Economic Analysis estimates that the average effective spread for New York Stock Exchange securities shrunk about 28 percent. The overall narrowing of spreads makes it likely that retail investors entering small orders have experienced reduced trading costs.
Significantly, decimal trading has not substantially increased quote traffic or overwhelmed capacity. While the number of quotation updates may have increased, decimal trading has not caused backlogs and outages.
Potential Impact of Subpennies
That was the easier part of the analysis. Converting to trading in dollars and cents raises a number of fundamental market structure and investor protection issues, such as:
- How will it alter the trading behavior of investors and other market participants?
- What sort of overall impact does it have on liquidity and transparency?
- How does it impact the market's functioning from an operational standpoint?
The Commission, of course, has previously considered these issues. When we debated decimalization in the past, however, it was on the premise that the minimum increment would be dimes or nickels, perhaps pennies. Partly because technology and competition had already narrowed spreads so significantly, we are now talking about the possibility of the entire market trading in increments of less than one cent.
Of course, subpenny trading is not new to ECNs. For several years now, some ECNs and market makers have allowed their customers to submit subpenny orders, even though the quotations are displayed in penny increments. Albeit limited to some 4 to 6 percent of trades in Nasdaq securities, and roughly 0.2 percent of trades in New York Stock Exchange securities, this practice continues in the decimal environment.
To help further debate on this important issue, I can report that the Commission today is issuing a concept release to solicit comment on subpenny trading. Specifically, we seek comment on how subpenny trading might impact liquidity, transparency, capacity, various investor protection and market integrity rules, as well as the trading behavior of market participants.
I assume that ECNs and some investors may support the subpenny environment as a place for greater price improvement opportunity, greater innovation and greater competition between markets, with more transparency of true trading interest. Other commenters may believe that allowing quoting and trading in increments of less than one cent could undermine the overall benefits of decimalization by causing investor confusion and a breakdown in the efficiency of our markets.
I want to take a few minutes to discuss some of the issues that the Release highlights regarding the potential impact that subpenny trading could have on the markets.
Rapidly Changing Price Quotations:
The "Flickering Quote"
We have seen the "speed of the inside" increase substantially with the implementation of decimals trading. More specifically, since decimalization, quote flickering – as measured by the number of inside quote updates – has grown on the regional exchanges, the third market, and on Nasdaq. Nasdaq reports that the number of inside quote, price-only updates increased by 90% following its final phase in of decimalization. Interestingly, quote updates on the NYSE appear to be less frequent. The potential for subpenny trading on a market wide basis could speed up the markets even further, impacting market participants in a number of ways.
First, subpenny pricing could undermine price clarity for investors and market participants by confusing them with rapidly changing quote montages. Second, flickering quotes in miniscule price increments could also raise issues about how broker-dealers should meet their best execution obligations for customer orders.
The duty of best execution requires a broker to seek the most advantageous terms available under the circumstances for a customer's transaction. In addition to other factors, a broker must take into account opportunities for price improvement, costs of the trade, speed of execution, and likelihood of execution. Subpenny trading on a market wide basis could complicate the best execution analysis by making it more difficult, among other things, to assess where the best price is available and to locate liquidity sufficient to achieve full execution of an order.
Finally, rapidly changing quotes in a subpenny environment could have ramifications on market rules limiting "locked" and "crossed" markets and trading at inferior prices. These various rules are dependent upon being able to identify the best bids and offers at a given point in time – a feat not easily accomplished when any given quote is only visible for a brief moment.
The Depth of the Quotation:
Decreased Transparency and Liquidity
As the minimum price increment has narrowed to a penny, the market depth at any particular price level and overall liquidity in the market appear to have decreased as well. Market depth represents the number of shares available at the published bid or offer. Our Office of Economic Analysis estimates that quote sizes in NYSE-listed stocks have decreased by an average of approximately 4,000 to 5,000 shares or 60 percent following the conversion to decimals. Preliminary analyses of Nasdaq securities show that quote sizes have decreased by an average of about 9,500 shares, or about 68 percent.
Market participants have indicated that smaller trading and quoting increments have increased the risk of displaying limit orders, particularly larger limit orders, reducing the amount of liquidity provided by such orders. If liquidity at the best quote shrinks and the number of shares available at the published bid or offer does not adequately represent trading interest, the fact that investors can see and understand the published bid and offer is less meaningful, particularly for larger investors. That is, transparency in the market is not terribly significant if there is nothing to see. Reducing the minimum price increment even further could exacerbate this problem.
Investor Protection and Market Integrity
Finally, decimal pricing – and the possibility of trading in subpennies on a market wide basis – raise several very difficult issues related to investor protection and market integrity. In particular, decimalization may undermine Commission and SRO rules that are dependent on trading or quoting price changes. If the market is constantly changing as a result of subpenny trading, priority rules that determine which orders are filled first, rules governing short sales, and rules protecting customer limit orders could be greatly affected.
For example, customer limit order protection rules provide customer limit orders with priority over specialist and market maker proprietary orders. Although specialists and market makers must yield to customer orders at a given price, they may "step ahead" of a customer limit order by trading at a price better than the existing limit order. At a penny or less, this becomes an inexpensive proposition. Specialists, market makers, and certain other market participants can easily profit from their knowledge of limit order flow by trading ahead of limit orders for only a penny a share. This could have a domino effect by causing public traders to change their trading behavior and strategies in an attempt to avoid having their orders "pennied." More specifically, rather than have their orders stepped in front of by a penny or less, public traders might begin to break their orders up into smaller sizes; they might direct their orders to several different trading venues; or they might opt to have a floor trader quietly work larger-sized orders rather than display such orders. The result could be increased transaction costs and reduced market liquidity.
I would be remiss, of course, not to mention some of the potential practical complications of subpenny quoting and trading, as well. If subpenny quoting and trading were permitted to occur on a market wide basis, how far out would the decimal point go? Should quotes run 9 decimal places or 99? Should we round the quote or display the subpenny quote? Is it in investors' and the market's overall best interest for a limited portion of the market to continue to trade, but not quote, in subpennies? Does subpenny price improvement have any true economic significance? Can the markets and automated systems handle the increased data flow? Would a subpenny environment be economically efficient for market participants?
Decimalization represents a dramatic and significant change to the structure of our markets that carries with it many benefits for investors. As with decimals generally, subpennies certainly have the potential to impact the structure of our markets, but I question whether the same benefits will follow. The Commission is very concerned about the potential impact that subpenny pricing could have on the efficiency and integrity of the U.S. markets.
Clearly, subpenny trading presents the Commission and market participants with difficult choices. I am hopeful that the various market participants will be able to decide upon a minimum price increment that will work for everyone and for the good of the market overall. I anticipate that the Concept Release comments, as well as the reports due from the stock exchanges and Nasdaq in September, will be extremely helpful in developing proposals that will preserve the benefits of decimalization and ensure that our markets remain orderly, transparent, liquid, and fair.
Stay tuned. Thank you.