Decimalization is only seven months away from replacing the fractional system used in the U.S. for quoting stocks. Retail investors may be pleased but some institutional traders are downright apprehensive.
"The market moves fast enough as it is," said Gary Kaplowitz, head of Nasdaq trading at Fahnestock & Co. in New York.
"Decimalization is going to increase the frequency of price fluctuations. Quotes will be all over the place, making it harder to get in and out of positions," he added.
Kaplowitz is worried about a Securities Industry Association-led plan to move the industry into a decimal-based trading environment – a plan that would see the current minimum increment tumbling lower.
Today's minimum tick of one-sixteenth, or 6.25 cents, could drop to a penny on many of the most heavily traded stocks. That could encourage traders to quote more small orders at the inside price. If it only costs a penny a share to trade, more investors will likely participate in the market. But that penny a share scenario would make it more difficult for Kaplowitz to execute large orders. He would have to work far more 100-share orders and at a faster rate than he does today.
The Outcome
Rapid-fire trading is possibly just one far-reaching result of how decimalization will affect both buyside and sellside traders. The sellside will see thinner spreads on large-cap Nasdaq stocks, such as Microsoft, Cisco and Dell Computer, according to the experts. The buyside will see reduced depth on listed markets, they add. The individual investor, however, is expected to be the big winner of stock prices in decimals.
But then that's the point. Decimalization was forced on the markets by Congress in 1997 partly to save retail investors billions of dollars per year. That was supposed to happen by the aforementioned reduction in minimum tick sizes by market centers like the New York Stock Exchange and Nasdaq.
Smaller trading increments would intensify competition among all sorts of limit order traders. Market makers, day-traders, hedge funds, and arbitrageurs would all try to better each other's quotes, leading to price improvement for the customer.
The "Common Cents Stock Pricing Act," or HR 1053, was introduced in the House by representatives Michael Oxley (R-Ohio) and Edward Markey (D-Mass) in March 1997. "A modern decimal system is better for small investors," Oxley said. "People are being eighth-ed and sixteenth-ed right out of their stock profits."
The bill required decimalization as quickly as the SEC thought it could handle it. Three months after the legislation was introduced, the NYSE voted to trade in decimals and cut the minimum trading increment from one-eighth to one-sixteenth. Oxley and Markey then pulled their bill. Nasdaq soon announced its own move to decimals. The SIA recently sent its plan to the Securities and Exchange Commission, calling for decimal trading to begin on July 3, 2000. Stocks would trade in nickel increments for three months, then in whatever increments decided upon by individual market centers. Most expect the tick to drop to a penny for the most active issues.
"I think we will see penny ticks for a couple of years before the markets realize their mistake," said Dan Weaver, a professor at Baruch College's Zicklin School of Business. "Eventually the market centers will get together and set a higher minimum." Weaver, a longtime scholar on the issue, believes five cents is low enough.
But Junius Peake, professor of finance at the University of Northern Colorado and a proponent of decimalization, says market forces should determine the minimum tick. "The New York Stock Exchange, among others, would like to maintain a large enough tick size to benefit from the inefficiencies of the market," Peake said. "But that unnecessarily increases the cost of trading. Any time you increase the cost you have less trading and fewer people involved. I mean it's Econ 101. If you reduce the price of something, people will buy more of it. Look what happened when they deregulated commissions in 1975."
Serious Concern
Most traders and market watchers say the initial drop in the tick size from one-sixteenth to a nickel will have little effect on trading conditions. It is the expected drop to one cent that has them worried.
"Anything less than five cents will be detrimental to the market as we know it," said Buzzy Geduld, president of wholesaler Herzog Heine Geduld. "It's the death knell for the principal business." Principal trading involves risking capital by taking positions in stocks.
Geduld and others are predicting that, once tick sizes drop to a penny, spreads will do the same. After the introduction of teeny' ticks and the increased competition from limit order traders, newly protected by the SEC's order handling rules, market makers' spreads fell about 30 percent in 1997. The same thing happened on the Toronto Stock Exchange when it converted to decimals three years ago. The minimum trading increment was cut from one-eighth, or 12.5 cents, to five cents for stocks trading over five dollars (Canadian). Spreads narrowed and trade sizes dropped as well, according to a study by Indiana University's Jeffrey Bacidore.
What's bad for wholesalers like Herzog, however, may not be bad for wirehouses like Merrill Lynch and Goldman Sachs. Wirehouses charge clients a credit,' or a form of commission, for executing Nasdaq trades. That payment is unlikely to drop much with decimalization, market insiders say. Today, credits are, at most, one-sixteenth per share, equal to the spreads on many socks.
If those spreads narrow, wholesalers will see profits pinched, but wirehouses are not expected to reduce the credits. All told, eight wholesalers and eight wirehouses control 70 percent of all Nasdaq trading, according to AutEx BlockData.
The Buyside
On the buyside, spreads are of less concern than liquidity. "Trading in size is more important for us," said Brian Pears, head of equity trading at Wells Capital Management. "We generally execute at average prices anyway."
The depth of the market, a key component of liquidity as measured by the number of shares available to trade, is not expected to change on Nasdaq. Market makers' best priced advertised quotes are accompanied by the number of shares they have publicly available. At the moment, that amounts to a bare minimum. The true depth of the market is not revealed. Quoted sizes aren't expected to drop further with decimalization.
Depth in the listed market is a different matter. "With penny increments it will be much easier for traders to jump in front of a large order," Weaver said. "Quoted depth will suffer because institutions will hold their orders back."
In other words, an institution with a large limit order will not automatically send it down to the floor because other traders would only need to better it by one cent to "steal" the trade. The institution would then pay more or receive less when it finally does execute. By holding the order back, the institution doesn't tip its hand, but it also reduces liquidity on the exchange.
Not all market participants are convinced that aggressive penny' traders will wreak havoc and engage in so-called penny jumping.' "I have a hard time believing that something's going to be $72.38 bid and $72.39 offer in size," said Tom Hearden, a trader at Menomonee Falls, Wisc.-based mutual fund giant Strong Capital Management.
"There will always be a little stuff floating around," he added, "but I just can't see the market being that efficient and people that willing to disclose that they have size. Penny markets will take a while to happen, if ever."
