I am Donald D. Kittell, Executive Vice President of the Securities Industry Association.
SIA worked with its member firms, the U.S. equities and options exchanges and NASDAQ, clearance and settlement organizations, service bureaus, market data vendors and the Securities and Exchange Commission to successfully convert the U.S. equities and options markets from fraction-formatted trading to decimal-formatted trading earlier this year. The conversion took three years to accomplish and cost in excess of $1 billion, according to estimates developed by the Tower Group on behalf of SIA. The conversion itself was accomplished smoothly, to the credit of all participants involved.
I have organized my comments on the impact of Decimalization into four subjects:
I would summarize SIA’s conclusions on the impact of Decimalization as follows:
Each market center is required by the SEC to submit a study to the Commission regarding the impact of decimal pricing on systems capacity, liquidity, and trading behavior, including an analysis of whether there should be a uniform minimum increment for a security. These studies are due June 9, 2001. In the interim, NASDAQ has released three decimal impact studies which area very useful. SIA has not seen impact studies from the other exchanges.
The conversion to decimals impacts at least four sets of trading rules and regulations. The exchanges, NASDAQ, self-regulatory organizations and SIA’s regulatory and trading committees are currently reviewing these rules and regulations as the industry gains experience in decimal trading.
The NYSE currently quotes and trades in penny increments. NASDAQ quotes in pennies but allows trading in mills. The options exchanges currently quote and trade in increments of five cents for options priced under $3 and of ten cents for options priced over $3.
Each exchange is anticipated to make recommendations as to minimum price variations in its June study.
A number of SEC and SRO rules are "triggered" by price ticks. Examples include the short sale rules, limit order disclosure and protection rules, and the intermarket trading system trade-through rule. Decimalization has resulted in industry participants questioning whether these rules can be effectively managed in a fast moving environment of fluctuating penny (or mill) ticks. Participants also question whether such ticks are economically significant. It may be that some of these rules should be triggered by large tick sizes.
The concept of "best execution" has been debated in the industry for many years, but the smaller pricing increments of decimals complicate the debate. It has long been recognized that the characteristics, which define "best execution", include factors other than pure price, such as speed of execution and size of trade. Decimalization has resulted in finer pricing increments, and at least in the case of NASDAQ, a greater number of trades outside of the best bid and offer.
The SEC has recently adopted two new rules governing the Disclosure of Order Execution and Routing Practices (Rule 11 Ac 1-5 for market centers and Rule 11 Ac 1-6 for broker-dealers).
Some SIA firms are concerned about the accuracy of the data that they will be reporting and the conclusions that may be drawn from this data – particularly about trades executed outside of the best bid and offer for legitimate business reasons .
Reporting under the SEC’s new disclosure rules will begin in June and be phased in between June and October 2001. SIA anticipates a great deal of discussion among industry participants, regulators and third party observers as to the accuracy and meaning of the newly reported data in a decimal environment.
Institutional trading desks have voiced concerns about the reduction in displayed depth as a result of Decimalization, as well as problems with entering limit orders and the breaking up of large orders as they interact with the NYSE auction.
SIA understands that a committee formed by the NYSE is addressing these and related issues. We look forward to the recommendations of this committee as well as to the introduction by the NYSE of new functionality to provide greater information about market depth. We understand that NASDAQ is also addressing the issue of greater displayed depth.
The ways in which market centers deal with integrating the institutional and retail markets to insure fairness to all market participants is a critical issue, made more complex by the conversion to decimal trading.
Decimalization has resulted in significant reductions in the quoted spreads (and "effective spreads") reported by market centers. The reduced spreads have given rise to conjecture as to the impact of Decimalization on specialist and market maker profitability, the future viability of payment for order flow, the prospect of NASDAQ market makers introducing commissions on top of "net trades," a possible increase in proprietary trading by market makers, the potential for capital being withdrawn from unprofitable market making activities and other issues of concern to market makers.
SIA firms are addressing these issues individually, and when appropriate, in trading and regulatory committees.
SIA’s conclusion at this stage of decimal trading, is that it is too early to tell how these issues will resolve themselves. The conversion from one-eighth trading to one-sixteenth trading took a number of months to settle down and the introduction of the new order-handling rules continues to evolve. It may be many months before we see a clear picture of the impact of Decimalization on market making activities.
It is clear that the benefits of Decimalization to investors is a complex subject which will be debated for some time. It is clear that the simpler "language" of decimals is a benefit. It is clear that the harmonization of decimals across financial products and across international markets is a benefit. SIA believes that removal of the cloud of suspicion surrounding fractions was a constructive step.
SIA has always been skeptical about the assertion that Decimalization would produce huge savings for investors as a result of reduced spreads. The arithmetic supporting this assertion is too simplistic to consider the effects of price movement, trade size, liquidity, transaction costs and other factors that govern the economics of trading.
SIA has also been skeptical about the issue of global competitiveness. A study conducted by SRI on behalf of SIA indicates that the U.S. equity markets are more than competitive with international equity markets in spite of the use of fractions.
SIA firms report complaints from both institutional and retail customers relative to the number of trades and the time required filling an order. Institutional firms report complaints about their inability to see displayed depth and to find liquidity.
Conclusions about market liquidity, trading volume, volatility, transaction costs, and the relative economic impacts upon market participants – institutional and retail customers as well as market markers and specialists – would, in our judgment, be premature until trading behavior settles down over the course of many months. We also suspect that it will be difficult to generalize these conclusions because experience will vary by type of security, type of market center and type of customer. Further, the experiences of each of these groups will vary as market activity changes over time.
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