Chairman Enzi, Senator Dodd, and members of the Subcommittee:
My name is Catherine Kinney, and I am Group Executive Vice President of the New York Stock Exchange ("NYSE" or "Exchange"). I am pleased to be here today to relate some of the preliminary results of decimal trading.
Decimalization has been the most important occurrence in our capital markets in the last quarter-century. Congress and the SEC directed this initiative to accomplish significant policy goals. The NYSE is pleased to have facilitated the conversion process. The benefits of decimal trading have been realized, but the shift to a minimum price variation ("MPV") of one cent has created some difficulties. The NYSE is already taking steps to remedy some of these detrimental effects. In this regard, we urge that an MPV of no less than one cent be established by Congress or the SEC across all markets. Otherwise, the current difficulties will become worse, and the benefits of decimalization may be jeopardized.
Conversion to Decimals
The Exchange recognizes that conversion to decimals was a high priority for a number of Congressional leaders and for the Securities and Exchange Commission ("SEC" or "Commission"). The Exchange made a commitment to convert to decimals, and we are proud that our conversion was accomplished without systems or capacity problems. Most of our decimal conversion costs were incurred simultaneously with our Year 2000 system conversion. These simultaneous system upgrades cost approximately $30 million.
Decimal trading has increased the number of possible trading increments within a dollar from 16 to 100. This increased number of trading increments has required an increase in capacity for our trading systems. Since 1988, we have spent nearly $3 billion on technology to maximize capacity. We currently have the capacity to trade five times our average daily volume. Today, the NYSE has sufficient capacity to handle 2000 messages, or orders, per second. Stated differently, capacity is 6 billion shares per day.
The Exchange launched decimal trading with a pilot project of seven stocks on August 28, 2000. Stocks in the pilot program were priced in dollars and cents instead of fractions, and the minimum pricing increment was one penny instead of one-sixteenth of a dollar. The pilot was extended to include 57 additional stocks on September 25, and 94 stocks were added on December 4. The Exchange completed the conversion by trading all 3,525 listed issues in decimals on January 29, 2001, more than two months ahead of the SEC’s deadline of April 9. Throughout the conversion process, all Exchange systems performed efficiently and without problems.
Trading in a Decimal Environment: The Early Results
We are confident that the conversion to decimal pricing has accomplished important public policy goals: It has brought U.S. markets into conformity with quoting and trading systems used around the world. This will help U.S. equity markets to expand their foreign listings, and will facilitate globalization of equity markets.
Our preliminary analysis of conversion to decimal pricing indicates that, on balance, the penny increment has been good for some retail investors. Stock prices in decimals are certainly more understandable. Over the last decade, direct share ownership by individual investors has increased, and decimal prices will encourage this trend by breaking down a barrier to understanding the market. Spreads have been reduced, and price improvement on the NYSE has increased.
The smaller price variation (a penny) encourages price competition. Results to date indicate a tightening of the bid-ask spread – the differential between the highest quote to buy (the "bid")and the lowest seller’s asking price (the "ask") – by approximately 37%. This is particularly beneficial to small investors, especially those trading in the most active stocks.
We have also seen an increase in price improvement, particularly for smaller orders. In orders that do not exceed the quoted size of the best bid or offer, the price improvement rate on the NYSE has increased from 35.2% to 50.7%.
On the other hand, the one-cent MPV has significantly impacted institutional investors. The Exchange has monitored, and continues to monitor, the effect of this change on investors and on the operation of the market. The market is continuing to acclimate to this new environment, and it is premature to draw any sweeping conclusions. But, we have observed some trends that I will summarize.
Decimal trading has had a number of detrimental impacts on mutual funds, pension funds and other institutional investors, who act on behalf of individual investors. These investors, who tend to trade in large blocks, have experienced a lack of transparency and reduced depth at the published NYSE quote (best bid and offer), and an increase in number of execution reports (i.e., the number of transactions necessary to fill an order). These market participants are an important source of liquidity.
We conducted a one-week analysis of a random sample of 150 stocks to assess the degree to which trades occurred at a minimum variation before and after decimalization when the bid or offer equaled or exceeded 10,000 shares. We found a significant decrease in occurrence in a one-cent variable compared to a 1/16th variable. We also found that a majority of these occurrences were initiated by a floor broker or an order received through the SuperDot system, rather than by a specialist.
The impact on the institutional investor is an inevitable outgrowth of the decrease in the minimum price variation from 6.25 cents to one cent. This decrease in the MPV has lowered the transparency of the market and thus made it harder for institutional investors to find the right price for the liquidity they require.
Our research to date shows a significant 67% decrease in the number of shares available at the published NYSE quote. While true liquidity (i.e., actual interest from all sources) available may not have been significantly impaired, there has been a significant impairment of transparency.
Nevertheless, because liquidity is spread-out over a number of price points, institutions have found that it takes significantly more trades in a decimal environment to execute a large order compared to trading in sixteenths. We have canvassed institutional investors serving on our Institutional Traders Advisory Committee, Pension Managers Advisory Committee and Advisory Committee on Decimalization, and this has been a leading complaint.
We have acted to address the transparency concerns of the institutional investor. The Exchange has initiated two changes to permit dissemination of "depth indications" and "depth conditions" in our listed securities. These initiatives are the first in a series of actions the Exchange will implement to improve transparency and communication of market depth in a decimal trading environment.
In March, the Exchange began to disseminate an "indicator" of additional market depth. The range is currently defined as 20,000 shares within 15 cents of the bid, offer, or both. Part two of this effort began this week, with the ability to disseminate "depth conditions." The "depth condition" shows liquidity beyond the best bid or offer without the pre-defined, limited parameters of the "depth indicator".
In addition, next month, we intend to introduce Open Book, which will provide data in orders residing at each price point in specialists’ display books. We also are proliferating hand-held technology called E-Broker, which allows floor brokers to electronically communicate "market looks" at the market depth to customers from the point of sale.
In addition, we have formed an Advisory Committee on Decimalization to review decimal trading at the Exchange and to make recommendations based on that assessment. The Committee is comprised of representatives from various Exchange constituencies, including representatives of our Pension Managers Advisory Committee, Institutional Traders Advisory Committee, the NYSE Board of Directors, and specialists and floor brokers. As more definitive information becomes available from our review of the effects of decimal pricing, we will certainly share it with the SEC.
The Future
The work of the Advisory Committee on Decimalization is ongoing, and it will continue meeting to consider initiatives to facilitate price discovery in a decimal environment. We are reviewing Exchange trading rules to ensure that they are appropriate for the changes that are occurring. We will also be working with academics to study these issues.
The SEC has requested that we provide a preliminary report by September 10 on the impact of decimal pricing on systems capacity, liquidity, and trading behavior, including an analysis of whether there should be a uniform minimum increment. The SEC has further requested all markets to submit by November 4 proposed rule changes establishing their individual choice of minimum pricing increments.
We believe an MPV of less than a penny would undermine the benefits that decimal pricing has brought to the markets, while at the same time exacerbating the problems that decimal pricing has caused for institutional investors. An MPV of less than a penny would provide no real benefit for individual investors. It would reverse the harmonization of U.S. pricing with that of overseas markets. And it certainly would be a step backwards in improving clarity of stock prices for individual investors.
In addition, the problems that institutional investors have faced in trading at an MPV of one cent would increase exponentially if markets were permitted to quote and trade in increments of less than one cent.
If the SEC decides to establish an MPV greater than a penny, we believe that the variation should apply to trades and quotes; to trade at a variation lower than the quote minimum would give dealers an unfair advantage.
The NYSE intends to be competitive in the marketplace under all circumstances as it relates to the issue of the MPV, and will continue to assess the best means of addressing the transparency problem resulting from liquidity dispersed over more price points.
I appreciate the opportunity to testify today, and I would be pleased to answer any questions.
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