Decimal Pricing in the Securities and Options Markets
By Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Subcommittee On Finance and Hazardous Materials
Committee on Commerce
United States House of Representatives
June 13, 2000
Chairman Oxley and Members of the Subcommittee:
I would like to thank Chairman Oxley and the members of the Subcommittee for the opportunity to testify on behalf of the U.S. Securities and Exchange Commission concerning the implementation of decimal pricing. Your leadership has paved the way for our nation's securities markets to begin making this truly revolutionary change this year.
I. Executive Summary
The convention of quoting stock prices in fractions dates back more than two hundred years. Currently, the United States securities markets are the only major markets not to price stocks in decimals. As the securities markets become more global, with many stocks traded in multiple jurisdictions, the U.S. securities markets need to adopt the international convention of decimal pricing to remain competitive. And the overall benefits of decimal pricing are likely to be significant. Investors may benefit from lower transaction costs due to narrower spreads.
Moreover, the markets will be easier to understand for the average investor, who is used to dealing in dollars and cents for every-day transactions. It is time for the U.S. securities markets to make this change.
The Commission recognizes the efforts of Chairman Oxley, Chairman Bliley, Congressman Markey, and other members of Congress in spearheading the conversion to decimal pricing. We want to assure you that the Commission is also committed to implementing decimal pricing as soon as possible. That is why the Commission issued an order directing the exchanges and Nasdaq to submit a plan that would phase in decimal pricing for listed stocks and certain options starting no later than September 5, 2000, and phase in decimal pricing for Nasdaq securities beginning no later than March 12, 2001.
Under the order, all securities must be priced in decimals no later than April 9, 2001 -- shortly after the end of the quarter.
I realize that many of you are frustrated with the pace of the U.S. markets' conversion to decimals. I share some of these frustrations. The Commission has been working with the securities industry to implement decimal pricing since 1997. Like Congress, we believe the time is right for the securities industry to convert to decimal pricing.
Nevertheless, it is critical that this conversion take place in a safe and orderly manner. The Commission has serious concerns about a full-scale conversion to decimal pricing in listed securities without an orderly phase-in. In particular, based on our discussions with the industry, we are concerned that making an immediate leap to decimal pricing could jeopardize systems capacity and capabilities. Without adequate time for planning and systems testing, an immediate full-scale conversion has the potential to create widespread operational problems, which in turn could adversely affect investors.
Of course, some of the planning and testing has already been completed. Most of these prior efforts, however, assumed that Nasdaq stocks would be converted to decimals at the same time as listed stocks. Any different plan to trade listed stocks in decimals, Nasdaq stocks in fractions, and some options in both, raises issues that must be addressed. For these reasons, we believe that the prudent approach is to phase-in decimals starting in September 2000 to ensure that the markets continue to operate in a fair and orderly manner, and that investors are fully apprised of the changes ahead. Nevertheless, we have left the markets and the securities industry the flexibility to set a more aggressive phase-in schedule, provided that they can satisfy themselves that there will be mimimal disruptions to the markets.
I will now briefly discuss the chronology of events leading up to this point, including the recent Commission order.
Throughout the mid and late 1990s, the Commission engaged the securities industry and the public in a discussion regarding the need for decimal pricing in the U.S. securities markets. On March 13, 1997, this debate moved to the legislative arena when Congressman Oxley introduced a bill in the U.S. House of Representatives that would have directed the Commission to adopt a rule requiring quotations in dollars and cents for transactions in equity securities. Subsequently, the New York Stock Exchange announced that it would implement decimal pricing by January 2000. Other markets soon followed suit. In light of this activity, the bill was not taken to full markup in the House Commerce Committee.
On May 8, 1998, the General Accounting Office ("GAO") determined that "[e]nsuring that securities industry systems are ready for the Year 2000 is too important to the continued functioning of the industry to risk failure by attempting to implement decimal trading before the Year 2000 effort is completed."
I concurred in this assessment, but I also noted the importance of setting a date certain by which the markets must move to decimal pricing. At that time, I believed that the industry should strive to implement decimal pricing by June 30, 2000.
On August 25, 1998, Commission staff requested that the exchanges and the National Association of Securities Dealers, Inc. ("NASD") provide information regarding the status of rule and systems changes that would need to be adopted to implement decimal pricing. Their responses indicated that a range of rules and systems would require modification to accommodate decimal pricing. Because of the impact of decimal pricing on the securities industry as a whole, virtually all the market participants, and the Commission, believed that a coordinated approach to implementation was necessary. To expedite the conversion to decimal pricing and to alleviate the industry's antitrust concerns,
on January 28, 2000, the Commission ordered the exchanges and NASD to begin implementing decimals on July 3, 2000, and to complete implementation for all equities and options within six months after the July 3rd date.
The January 28th
order also required the markets to submit, by March 13, 2000, a joint plan detailing specifically how decimal pricing would be implemented. To mitigate the potential strain on the computer capacity of the industry and to minimize the potential for systems errors, the order permitted the markets to phase-in decimals over several months and permitted trading to begin in nickel increments for equities and greater increments for options.
Prior to issuing the January 28th
order, the Commission staff surveyed the exchanges and NASD regarding their preparation for decimal pricing. I understand that Nasdaq officials informed the staff that Nasdaq would be ready for a decimal pilot by July 3rd. In late February, Nasdaq reaffirmed its readiness in its formal response to the survey, but indicated that it was continuing testing to confirm its readiness. As I understand it, the testing revealed unexpected capacity problems stemming, in part, from unprecedented volume surges. On March 6, 2000, the NASD announced that it would not have sufficient capacity to meet the target dates for implementation.
The NASD also expressed concerns regarding overall industry readiness and requested that the Commission work with the industry and the markets to determine an appropriate time frame that would not impose unnecessary risks on investors. Moreover, the NASD said that it was not able to determine when it would be ready to implement decimal pricing. As a result, on March 10, 2000, the Commission issued an order delaying the March deadlines for approximately one month.
In addition to the March 10th
order, I sent a letter to each of the markets requesting their opinions regarding issues central to the implementation of decimal pricing. These issues included:
whether or not it would be feasible or advisable to implement decimal pricing in exchange-listed securities while Nasdaq securities continued to trade in fractions;
whether or not it would be feasible to trade the same securities in decimals on an exchange and in fractions on Nasdaq; and
what the impact of trading the same securities in fractions and decimals would be on the options markets.
In response, the exchanges indicated that their individual systems are capable of converting to decimal pricing by July 3, 2000, though many of them expressed concerns about the readiness of the securities industry as a whole. The NASD asserted that Nasdaq has sufficient capacity to implement decimal pricing for market makers trading exchange-listed securities (i.e., the third market) by September 4, 2000, with full implementation of decimal pricing by March 31, 2001. Two electronic communications networks stated that they are prepared for decimals, and that trading exchange-listed securities in decimals should not be delayed because of Nasdaq's inability to meet the July 3rd target date.
The vast majority of the markets and securities firms, however, believed that it would be difficult and confusing to implement widespread trading of exchange-listed securities in decimals while trading of Nasdaq securities remains in fractions. Many responses indicated that bifurcating the implementation of decimal pricing for different markets on other than a pilot basis raised serious concerns. For example, some responses indicated that trading of Nasdaq stocks in fractions and exchange-listed securities in decimals over an extended period of time could prove costly to markets, broker-dealers, and vendors. In addition, the Financial Industry Forum ("FIF") pointed out that systems would have to be adapted to perform price format checking for each and every security traded in a different format. Without this format checking, and considering the investor confusion caused by mixed pricing, the FIF believed that error rates and corresponding order rejection rates could sharply increase. Moreover, the Securities Industry Association's ("SIA") Testing and Implementation Subcommittee warned that piecemeal testing of systems would be inefficient. The SIA's experts found that any testing that was conducted at a point in time that was distant from the implementation date would not provide an accurate determination of readiness.
III. Decimals Phase-In Plan
In view of these comments, on April 13, 2000, the Commission stayed the deadlines in the original Decimals Order and solicited public comment on two alternative proposals for decimal implementation.8
In the first alternative, the Commission requested comment on the advisability of pricing all exchange-listed securities in decimals (in nickel or penny increments) by September 4, 2000 ("Dual Pricing"). In the second alternative, the Commission requested comment on the advisability of phasing in decimal pricing in certain exchange-listed securities on a pilot basis ("Decimals Pilot").
The Commission received 36 comment letters on these decimal implementation alternatives. Some commenters urged the Commission to delay decimalization until all markets are prepared for decimals. Others supported full decimalization for both exchange-listed and Nasdaq securities either immediately or no later than the July 3, 2000 start-up date proposed in the Commission's Decimals Order. The largest number of commenters, consisting of broker-dealers, exchanges, clearing organizations, the NASD, and the SIA, believed that some form of phased-in dual pricing starting on or about September 5 would be both feasible and advisable.
The commenters who preferred a phased-in approach varied on the optimal method for achieving this approach. Most of these commenters advocated an extended pilot of only a small number of listed securities (along the lines of the Decimals Pilot alternative proposed for comment in the April Order), with most listed securities moving to decimals at the same time as Nasdaq securities. For example, the SIA believed that a pilot was more feasible than Dual Pricing because Dual Pricing would create major difficulties for the securities industry in creating and maintaining separate processes, systems, and programs to trade large number of securities in decimals while many others trade in fractions. The SIA also believed that a pilot would simplify educational efforts designed to inform the investing public of the way in which specific securities would be priced. Other commenters, however, thought it possible to phase-in decimal pricing in all exchange-listed securities more quickly. The New York Stock Exchange, for example, favored commencing decimal pricing in a limited number of NYSE-listed securities, advancing to a full pilot of perhaps 50 NYSE-listed securities during an initial phase-in period of one month or less. The New York Stock Exchange indicated that an expansion to all of its listed securities could prudently occur after approximately 60 days of trading in all pilot stocks. All of the commenters stressed the need for careful planning and systems testing to avoid potential market disruptions and to minimize investor confusion.
The Commission carefully considered the comments, particularly the request of Congressmen Oxley, Bliley, and Markey to implement decimal pricing in all exchange-listed securities by September 4, 2000. In view of the concerns raised by commenters and our own discussions with industry participants, the Commission came to the conclusion that an immediate full-scale introduction of decimalization in listed stocks, without adequate planning and systems testing, had the potential to create widespread operational problems in the markets and the securities industry, which in turn could adversely affect investors.
The Commission therefore ordered the exchanges and Nasdaq to submit a plan that would phase in decimal pricing for listed stocks and certain options starting no later than September 5, 2000, and phase in decimal pricing for Nasdaq securities beginning no later than March 12, 2001.9
Under the order, all securities must be priced in decimals no later than April 9, 2001 -- shortly after the end of the quarter.
A phase-in period should give the industry time to finalize testing, to adjust their systems to correct errors as they phase in particular stocks in decimals, to educate investors, and to monitor changes in trading behavior. In particular, trading in decimals, especially in penny increments, may affect the use and display of customer limit orders, the liquidity of certain stocks, and the ability to sell short. A phase-in period, even a short one, will allow the Commission and the markets to monitor the impact of decimalization on trading behavior and to determine if trading rules need to be adjusted.
The Commission did not mandate widespread Dual Pricing ahead of Nasdaq's projected decimal date because of the potentially serious systems and capacity problems raised by market participants. In view of the New York Stock Exchange's position and other comments on a more rapid move to full Dual Pricing, the Commission did not want to foreclose the possibility that the problems could be addressed and broader decimal trading begin in listed stocks before April 9. Therefore, the Commission's order gives industry participants the flexibility to begin broader Dual Pricing between September of this year and April of next year. If operational issues can be addressed and investor confusion can be minimized through educational efforts within a shorter time frame -- such as the one suggested by the NYSE -- the order allows the industry to move to full decimalization well before April 9, 2001.
As for quoting increments, there was little agreement among the commenters regarding a minimum increment during the phase-in period -- suggestions ranged from a dime to a penny. Accordingly, in its order, the Commission allowed the exchanges and NASD to fix the minimum quoting increment during the phase-in period, provided that the minimum increment is no greater than five cents and no less than one cent for any equity security, and that at least some equity securities are quoted in one-cent minimum increments. We fully expect that the pilot in listed stocks under consideration will trade in penny increments.
Finally, the Commission directed the exchanges and NASD to submit (either individually or jointly) a study to the Commission on June 9, 2001, that evaluates the impact of decimals on trading patterns and capacity and that makes a recommendation regarding a minimum increment, if any. Further, the order directed the exchanges and NASD to submit rule change proposals to the Commission thirty days after submitting the study that would establish their individual choice of minimum increments by which equities or options are quoted on their respective markets
IV. Nasdaq Capacity
Before I conclude, I would like to briefly address Nasdaq's technology and planning. As I indicated above, the unprecedented growth in volume and quote traffic is presenting the Nasdaq market with formidable challenges, and I am committed to ensuring that Nasdaq faces them squarely. Last August and September, my staff reviewed Nasdaq's computer operations and identified to Nasdaq staff concerns about Nasdaq's capacity planning. In January of this year, the staff issued a report to Nasdaq identifying systems capacity as a key concern and recommending that Nasdaq obtain an independent assessment of its infrastructure capacity and its capacity planning process.
In response to Nasdaq's announcement that it would not be decimal ready by July 3rd, we prompted Nasdaq to accelerate its process for hiring an independent consultant to evaluate Nasdaq systems capacity and capacity planning. That review is nearing completion. Since that time, we also have closely monitored Nasdaq's progress with decimal implementation, including weekly conference calls with Nasdaq's Chief Information Officer. Last week, I personally met with Nasdaq management, including its Chief Information Officer, to discuss its readiness for decimals and broader capacity issues. We believe that Nasdaq is taking seriously the challenges presented by the conversion to decimals, as well as other capacity issues. Our goal is to see to it that Nasdaq remains on schedule for decimalization in Spring of next year.
In conclusion, because of your leadership, decimalization will become a reality this year, and investors will soon reap the benefits of trading in decimal increments. The Commission remains committed to implementing decimal pricing in a safe and orderly manner, with minimal disruptions to the markets. We appreciate your leadership on this.
The Canadian exchanges implemented decimal pricing on April 15, 1996. This change reduced the minimum tick size on the primary Canadian exchange, the Toronto Stock Exchange ("TSE"), from 12.5 cents to 5 cents for stocks trading above $5. For stocks trading between $3 and $5, the minimum tick size was reduced from 5 cents to 1 cent. The minimum tick size for stocks trading under $3 was unchanged. According to a 1997 study, spreads for stocks listed solely on the TSE narrowed by 20.18%. This study also indicated that investors save 139 million Canadian dollars per year as a result of the narrowing of the spread (or 102 million U.S. dollars). Because the value of shares traded annually in the U.S. is approximately 30 times that on the Canadian markets, the potential cost savings for U.S. investors that trade at the spread using market orders could be significant.
Jeffery M. Bacidore,
The Impact of Decimalization on Market Quality: An Empirical Investigation of the Toronto Stock Exchange
, 6 Journal of Financial Intermediation 92, 100-115 (1997).
Securities Exchange Act Release No. 42914 (June 8, 2000).
Testimony of Thomas J. McCool, Director, Financial Institutions and Markets Issues, GAO, before the Subcommittee on Finance and Hazardous Materials, Committee on Commerce, U.S. House of Representatives on May 8, 1998. The GAO also recommended that the Commission, in directing the securities industry's move to decimal pricing, assess: (1) the potential impact of decimal trading on the industry's processing and communication capacity; and (2) the impact on market regulations and exchange rules.
As joint discussions regarding the implementation of decimal pricing became more detailed, the exchanges and NASD began voicing concerns regarding antitrust liability.
, letter from Colleen P. Mahoney to Harvey J. Goldschmid, General Counsel, Commission, dated October 14, 1999.
Securities Exchange Act Release 42360 (Jan. 28, 2000), 65 FR 5004 (Feb. 2, 2000) ("Decimals Order").
Securities Exchange Act Release No. 42516 (March 10, 2000), 65 FR 14637 (March 17, 2000).
After receiving responses from the markets regarding these questions, the Commission, on April 13, 2000, issued an order suspending the current deadlines for the implementation of decimal pricing.
Securities Exchange Act Release 42685 (April 13, 2000), 65 FR 21046 (April 19, 2000) ("April Order").