[Senate Hearing 107-346]
[From the U.S. Government Printing Office]



                                                        S. Hrg. 107-346


                     THE IMPLEMENTATION AND FUTURE
                         OF DECIMALIZED MARKETS

=======================================================================

                                HEARING

                               before the

               SUBCOMMITTEE ON SECURITIES AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

                                   ON

THE CURRENT STATUS OF IMPLEMENTATION OF DECIMAL PRICING FOR SECURITIES, 
             INCLUDING AN ESTIMATION OF COSTS AND BENEFITS

                               __________

                              MAY 24, 2001

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

78-288              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2002
____________________________________________________________________________
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      PHIL GRAMM, Texas, Chairman

RICHARD C. SHELBY, Alabama           PAUL S. SARBANES, Maryland
ROBERT F. BENNETT, Utah              CHRISTOPHER J. DODD, Connecticut
WAYNE ALLARD, Colorado               TIM JOHNSON, South Dakota
MICHAEL B. ENZI, Wyoming             JACK REED, Rhode Island
CHUCK HAGEL, Nebraska                CHARLES E. SCHUMER, New York
RICK SANTORUM, Pennsylvania          EVAN BAYH, Indiana
JIM BUNNING, Kentucky                ZELL MILLER, Georgia
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN ENSIGN, Nevada                  DEBBIE STABENOW, Michigan
                                     JON S. CORZINE, New Jersey

                   Wayne A. Abernathy, Staff Director

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                      Linda L. Lord, Chief Counsel

                 Dean V. Shahinian, Democratic Counsel

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Securities and Investment

                   MICHAEL B. ENZI, Wyoming, Chairman

            CHRISTOPHER J. DODD, Connecticut, Ranking Member

RICHARD C. SHELBY, Alabama           TIM JOHNSON, South Dakota
MIKE CRAPO, Idaho                    JACK REED, Rhode Island
ROBERT F. BENNETT, Utah              CHARLES E. SCHUMER, New York
WAYNE ALLARD, Colorado               EVAN BAYH, Indiana
CHUCK HAGEL, Nebraska                JON S. CORZINE, New Jersey
RICK SANTORUM, Pennsylvania          THOMAS R. CARPER, Delaware
JIM BUNNING, Kentucky                DEBBIE STABENOW, Michigan

             Katherine McGuire, Subcommittee Staff Director

                 Joel Oswald, Professional Staff Member

                                  (ii)


                            C O N T E N T S

                              ----------                              

                         THURSDAY, MAY 24, 2001

                                                                   Page

Opening statement of Senator Enzi................................     1

Opening statement of Senator Corzine.............................     2

                               WITNESSES

Laura S. Unger, Acting Chairman, U.S. Securities and Exchange 
  Commission, Washington, DC.....................................     2
    Prepared statement...........................................    25
    Response to written questions of Senator Enzi................    56
J. Patrick Campbell, President, Nasdaq, U.S. Markets and Chief 
  Executive Officer, The Nasdaq Stock Market, Washington, DC.....     7
    Prepared statement...........................................    33
Catherine R. Kinney, Group Executive Vice President, New York 
  Stock Exchange, Washington, DC.................................     9
    Prepared statement...........................................    35
    Response to written questions of Senator Enzi................    57
Kenneth D. Pasternak, Chairman and Chief Executive Officer, 
  Knight Trading Group, Inc., Jersey City, NJ....................    11
    Prepared statement...........................................    37
Donald D. Kittell, Executive Vice President, Securities Industry 
  Association, Washington, DC....................................    13
    Prepared statement...........................................    41
Peter Jenkins, Managing Director and Head of Global Equity 
  Trading, Zurich Scudder Investments, New York, NY..............    14
    Prepared statement...........................................    46
Robert B. Fagenson, Vice Chairman, Van der Moolen Specialist USA, 
  LLC, New York, NY..............................................    16
    Prepared statement...........................................    53

                                 (iii)

 
          THE IMPLEMENTATION AND FUTURE OF DECIMALIZED MARKETS

                              ----------                              


                         THURSDAY, MAY 24, 2001

                               U.S. Senate,
  Committee on Banking, Housing, and Urban Affairs,
                 Subcommittee on Securities and Investment,
                                                    Washington, DC.

    The Subcommittee met at 10 a.m., in room SD-538 of the 
Dirksen Senate Office Building, Senator Michael B. Enzi 
(Chairman of the Subcommittee) presiding.

          OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Let me call the Subcommittee to order.
    I am not sure how many people will be attending. There are 
a number of things happening in Washington today, virtually at 
this moment. But some of us intend to get the business at hand 
done.
    I want to thank Ms. Laura Unger and the other witnesses 
today for taking the time to appear before this Subcommittee 
and share their views on how decimalization has affected the 
U.S. securities market.
    While we always compress a little bit to get the main 
substance from the testimony, everyone's complete testimony 
will appear as part of the record. When the hearing is over, we 
will leave the record open for additional questions for those 
of my colleagues who may not make it in at some point during 
the hearing.
    The use of decimal pricing marks a fundamental change to 
the way the market participants interact. As with any 
significant change, it will take time to fully adjust to the 
new pricing increments. Most of the reported problems 
associated with decimali-zation are not new. Instead, they are 
old problems that have been exacerbated and the phraseology has 
changed a little bit by decimalization. However, there have 
been some benefits to the decimal conversion, such as the 
narrowing of spreads. Additionally, securities are now priced 
as all other countries' are priced--and that is in decimal 
increments.
    I am very confident that the industry will fully adjust to 
the decimalization of the securities markets. These challenges 
will provide the Subcommittee with an opportunity to examine 
the structure of the market. It calls for reviewing the need of 
certain rules, such as the short-sale and trade-through rules. 
The Subcommittee will continue to work with the industry to 
ensure that any adjustments made are in the best interest of 
investors and the U.S. 
capital markets.
    I look forward to hearing the testimony of everyone today. 
I appreciate Senator Corzine being here and invite him to move 
closer to the front if he would like.
    [Laughter.]
    I know that got him in trouble once.
    [Laughter.]

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. It would be my pleasure, Mr. Chairman.
    I want to thank you and Senator Dodd for having this 
hearing. This happens to be something that I have spent a 
little bit of time with on the other side of table.
    I am very much supportive of and know that there are 
transitional issues here, but one that I think in the long run 
will serve investors and the providers of investment services 
great advantage over the long run. I am anxious to hear how 
this is going and look forward to hearing the testimony.
    Senator Enzi. Thank you.
    Our first witness today is Ms. Laura Unger, the Acting 
Chairman of the U.S. Securities and Exchange Commission. We are 
anxious to hear your testimony. Go ahead and begin.

                  STATEMENT OF LAURA S. UNGER

                        ACTING CHAIRMAN

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Ms. Unger. Chairman Enzi, and Senator Corzine, thank you 
very much for your invitation to speak.
    I am pleased to testify today on behalf of the Securities 
and Exchange Commission about the recent conversion to decimal 
pricing and the effects that this change has had on market 
dynamics and trading behavior.
    As you know, under the leadership of Congress, over the 
past year, U.S. markets have successfully moved from pricing 
shares in fractions to pricing shares like everything else, as 
you said, Chairman Enzi, in dollars and cents. The goal of 
decimalization was to simplify pricing for investors and to 
make our markets more competitive internationally. 
Decimalization was also expected to ultimately reduce trading 
costs for investors by narrowing quotation spreads, from the 
\1/16\ minimum increment, or 6.25 cents, that was standard in 
the fractional environment, to a penny.
    While comprehensive analyses of the market effects of 
decimalization are not yet available, I am pleased to report 
that preliminary reviews by the Commission and the markets 
indicate that these goals have been largely met. For example, 
quotation spreads in New York Stock Exchange securities 
narrowed an average of 37 percent, and effective spreads in 
those securities narrowed about 15 percent. An even more 
dramatic reduction in quotation spreads was observed in Nasdaq 
securities, with spreads narrowing an average of 50 percent. 
While it is difficult to estimate the overall cost savings to 
investors, the narrowing of spreads makes it likely that 
investors entering small orders that are executed at or within 
the quotes are experiencing reduced trading costs.
    Nevertheless, we recognized that the shift to decimal 
pricing was a fundamental market structure change that had the 
potential to affect the transparency, liquidity, and fairness 
of the markets. So, as a result, in June 2,000, the Commission 
required that the markets carefully phase-in decimal pricing. 
We also hosted a roundtable last December to solicit views on 
how the early phases of decimalization were affecting markets 
and trading.
    In addition, the Commission has asked the markets to 
conduct their own studies that would analyze how the conversion 
was affecting systems capacity, liquidity, and trading 
behavior, as well as investor protection. In view of the 
complexity of these issues, the Commission has extended the 
deadline for these markets' studies from July 8 to September 
10, 2001. In the meantime, we are continuing to work with the 
markets and market participants to identify any aspects of 
decimalization that might compromise the fair and orderly 
operation of the securities markets.
    Today, I would like to focus on how decimalization has 
affected market transparency, liquidity, and key investor 
protections.
    As far as market transparency and liquidity are concerned, 
as the minimum quoting increment has narrowed to a penny, the 
market depth--the number of shares available at the published 
bid or offer--has decreased as well. Preliminary estimates 
indicate that the New York Stock Exchange quote sizes have been 
reduced an average of 60 percent since the decimal conversion, 
and Nasdaq quote sizes have been reduced about 68 percent. Some 
firms and institutional investors have expressed concerns that 
the reduction in quoted market depth may be adversely affecting 
their ability to execute large orders. They have indicated that 
smaller pricing increments have increased the risk that large 
limit orders will not be executed. Instead, other market 
participants will use the information provided by these limit 
orders to step ahead of the orders for a penny. This practice 
could ultimately lead to a reduction in the amount of 
liquidity.
    In an effort to provide more information about available 
liquidity, the Commission accelerated the approval of a New 
York Stock Exchange rule change in March of this year to 
disseminate ``depth 
indications'' and ``depth conditions'' to reflect market 
interest in a security below the published bid and above the 
published offer.
    Decimal pricing also raises a number of key investor 
protection issues. For example, Commission and market rules 
protect customer limit orders by providing them with priority 
over specialist and market maker proprietary orders at the same 
price. New York Stock Exchange and NASD rules require that a 
specialist or market-maker who wants to ``step ahead'' of a 
customer limit order pay a price that is greater than the limit 
order by at least the minimum quoting increment. With the 
conversion to decimals, this minimum increment is only a penny. 
This means it will be less costly for specialists, market 
makers, and possibly other market participants to profit from 
their knowledge of limit order flow by trading ahead of limit 
orders for only a penny a share. The fact that professionals 
may have an unfair advantage over the little guy is of concern 
to the Commission. So, together with the SRO's, we are 
currently gathering information about the operation of these 
investor protection rules in the decimal environment and will 
consider whether any action is necessary to protect investors.
    Finally, I should note that many of the issues raised by 
decimals may be exacerbated by the practice of trading at 
increments of less than a penny, so-called ``subpenny'' 
trading. Subpenny trades by electronic trading systems and 
market makers currently account for only about 4 to 6 percent 
of trades in Nasdaq securities. But the Commission intends to 
further study the impact of subpenny trading on market 
transparency and liquidity, as well as investor protection and 
market integrity rules.
    In summary, while the decimal conversion went smoothly from 
an operational standpoint, our work in this area is far from 
complete. I want to assure you that the Commission will 
continue to work with the markets and the securities industry 
to address potential problems while preserving the benefits of 
decimalization.
    We appreciate the continuing interest of the Subcommittee 
in this issue and the role that the Subcommittee has played in 
helping to ensure a smooth transition to decimals.
    Thank you very much.
    Senator Enzi. Thank you for what you said and your more 
extensive testimony.
    We are all anxious to see what direction things are going 
and what changes might be made. In your testimony, you 
mentioned that the Securities and Exchange Commission approved 
a pilot rule filed by NASD, specifying certain protections to 
customer limit orders priced in increments smaller than a 
penny, or subpennies.
    Do you believe there is a trading increment that might be 
too small for efficiencies to be realized in the market, 
particularly in the listed market? Is there a minimum increment 
that should 
be set?
    Ms. Unger. Well, Mr. Chairman, when we were talking about 
the conversion to decimals, the biggest debate was whether it 
would be nickels or pennies. At that time no one really 
contemplated that it would be something smaller than pennies. 
We are all very surprised by a conversation about subpennies. 
But that is the conversation that we are having.
    It is not something that the Commission would like to 
dictate in terms of what the appropriate increment should be. 
We are concerned about some of the issues that the smaller 
increments will raise in terms of our regulatory responsibility 
over the marketplace. And those are, capacity issues and the 
whole issue of stepping ahead of a customer order, the smaller 
the increment, the easier it is, and the more incentive you 
might have to do it.
    It could result in less transparency. If people stop using 
limit orders because they are not getting filled because they 
are being stepped ahead of, then what will happen to 
transparency in the market overall?
    I do not think we want to dictate to the industry on this 
issue and would prefer an industry solution to this problem. 
But I would assume it is a problem for them as well.
    I am saying, no, we do not want to say what the increments 
are.
    Senator Enzi. Okay. You are not suggesting a change at the 
moment.
    Ms. Unger. No, I do not think so. But, again, the notion of 
trading in subpennies raises a number of regulatory issues. And 
also flickering quotes and complying with the short-sale rule 
and a whole host of other issues. We are expecting to hear from 
the industry what their recommendations will be. We will have 
more statistical information about what the exchanges 
experienced with decimals trading in the fall, and they will 
have to submit to us rule changes by November 10.
    Senator Enzi. You mentioned the short-sale rule, and that 
you are gathering data and considering changes. I know that the 
SEC began its concept release in October 1999, which seems to 
be an adequate time for review, even in the light of the 
relatively new decimal pricing. What changes are you 
considering and when do you expect to have a change of that 
rule?
    Ms. Unger. With respect to the short-sale rule?
    Senator Enzi. Yes.
    Ms. Unger. I think we take the position that the short-sale 
rule doesn't make sense as currently drafted in the decimals 
environment because of the flickering quote issue. It is too 
hard to comply with the rule, and it would be too easy to 
manipulate.
    We are working right now diligently on drafting a rule 
change, and we should be ready to release a draft of that soon, 
and put it out for comment.
    Senator Enzi. Senator Corzine.
    Senator Corzine. Has the concept of block trading been 
affected by the decimalization, which gets at much of the depth 
issue.
    Ms. Unger. Right. I would assume that if people are talking 
about an order of a thousand shares being difficult to fill in 
the decimals environment--not difficult to fill--but requiring 
more transactions to complete, that block trading would be 
affected by decimals as well.
    I have not heard a lot of anecdotal evidence about that 
specifically, other than that the institutions seem more 
concerned about the limit order issue and not having the orders 
filled. So I suspect we will have more information about that, 
and perhaps the New York Stock Exchange has something on that.
    Senator Corzine. Right. In the depth indicators, has there 
been an embracing of this concept? Is it working? How do you 
feel? You commented on it. I am actually curious how that 
works.
    Ms. Unger. Well, the depth indicator is not very precise at 
this point. I think all it shows is that there are a certain 
number of shares within a parameter, a price parameter, where 
there is an interest. But it does not say how many shares and 
at what price.
    The New York Stock Exchange is refining that a little bit 
more and will be working on providing some more specific 
information as to the depth of interest.
    Senator Corzine. Refresh me. Nasdaq actually shows the 
depth indicators, makes it available, the amount of shares 
sought or offered at a particular price level.
    Ms. Unger. At a particular price level--at a quote, yes. 
But I am not sure that it is to the extent that you are talking 
about.
    And I think the Super-Montage proposal that was approved by 
the Commission would probably address a lot of the concerns in 
terms of showing the depth of the book further down than the 
quoted price.
    Senator Corzine. It seems that a number of those kinds of 
transparency initiatives might correct some of these problems. 
Are those being reviewed by the industry or asked to be 
commented and promoted as concepts, or at least considered as 
concepts?
    Ms. Unger. So far, the only thing that the Commission has 
received in terms of a proposed rule by one of the SRO's is the 
New York Stock Exchange's depth quote proposal. And we approved 
it expeditiously on an accelerated basis. So, yes, we would 
embrace solutions to this problem of showing the depth in a 
quote.
    Senator Corzine. Is there anecdotal evidence of charges of 
stepping ahead, or front-running, by small increments to break 
up trading patterns?
    Ms. Unger. Yes. As I said in the testimony, there is 
concern particularly among institutional investors that the 
limit orders will go away because of the fact that it is so 
easy to step ahead of the limit orders and they are not being 
filled.
    There is a concern, then, if there aren't limit orders, 
which the order handling rules require to be displayed, what 
will happen to the transparency in the marketplace? And that is 
actually a step backward in terms of enhanced transparency. 
That is something that we are definitely concerned about.
    Senator Corzine. And the available liquidity issues, you 
always have the risk of a fallacy of composition. We have gone 
through a much more turbulent or volatile period in the first 4 
or 5 months of the year. I presume that the overlay of that in 
conjunction with the change to decimalization could have 
different interpretations.
    There is different levels of liquidity, I suppose, in so-
called bear markets or highly volatile markets than there would 
be in straight-line moves.
    Ms. Unger. Well, I haven't heard of any studies tying the 
volatility of the market to decimals trading. I think it is all 
Regulation FD, actually.
    And not that, either.
    [Laughter.]
    Senator Corzine. I would encourage, though, that when one 
looks at whether decimalization is working, and I use it as a 
generalization, we want to be careful that one doesn't confuse 
a different market environment for the diminishment of 
liquidity versus the execution of the decimalization process 
because it wouldn't be intuitively obvious whether it was 
because markets are volatile and would have been volatile in 
other environments as well, and you might have less activity.
    Ms. Unger. Where it really comes into question is if you 
have customer orders of, say, over a thousand shares. Then it 
is hard for us to ascertain what the cost savings is that 
decimals provide, because if you have to execute that trade or 
transaction in multiple trades, then you have trading costs 
associated with that. And do those trading costs then exceed 
the savings that you have by a narrowed spread brought about by 
decimals?
    Senator Corzine. Right.
    Ms. Unger. So that is really something that is going to 
take a little time to figure out.
    Senator Corzine. Thank you, Mr. Chairman.
    Senator Enzi. I want to thank you for your testimony and 
the questions that you have answered. And I am sure that there 
will be more questions.
    There are a number of meetings that an hour ago were not 
scheduled around the Senate that are happening at the moment to 
figure out some changes that are in process. So several of the 
Members interested in this hearing were not able to be here.
    Ms. Unger. Thank you very much for the opportunity to 
testify, Mr. Chairman.
    Senator Corzine. Thank you.
    Ms. Unger. If any of the Members have any follow-up 
questions that they would like to submit, of course, we would 
be happy to answer them in writing.
    Senator Enzi. Thank you very much.
    Ms. Unger. Thank you.
    Senator Enzi. Our next panel consists of: Mr. J. Patrick 
Campbell, who is the President of Nasdaq U.S. Markets and the 
Chief Operating Officer of The Nasdaq Stock Market, Inc.; Ms. 
Catherine R. Kinney, Group Executive Vice President of the New 
York Stock Exchange; Mr. Kenneth D. Pasternak, Chairman and 
Chief Executive Officer, Knight Trading Group, Inc.; Mr. Don 
Kittell, Executive Vice President of the Securities Industry 
Association; Mr. Peter Jenkins, Managing Director and Head 
Equity Trader of Zurich Scudder Investments; and Mr. Robert B. 
Fagenson, Vice Chairman of Van der Moolen Specialists USA.
    I thank all of you for being here this morning. Again, we 
have all of your testimony as part of the record. So if you can 
summarize that for us and make your comments in a 5 minute 
period, we would appreciate it.
    Mr. Campbell.

                STATEMENT OF J. PATRICK CAMPBELL

              PRESIDENT, NASDAQ, U.S. MARKETS AND

        CHIEF OPERATING OFFICER, THE NASDAQ STOCK MARKET

    Mr. Campbell. Good morning, Chairman Enzi, Senator Corzine.
    I am Pat Campbell, President of Nasdaq U.S. Markets and 
Chief Operating Officer of The Nasdaq Stock Market. We welcome 
this opportunity to share with you our experience and insights 
into the recent conversion to decimal pricing on the Nasdaq 
market, although it has only been about 7 weeks.
    As the world's largest stock market, ensuring that 
decimalization was not disruptive to our investors and the U.S. 
capital markets was our primary concern. Crucial to our job as 
the world's largest provider of stock quote information is 
maintaining the availability, integrity and accessibility of 
this data. The estimates of increased computer demands prior to 
decimalization made switching a challenging project. One study 
projected a three-fold increase in quotation traffic. 
Decimalization takes the market from 16 price points per dollar 
to 100 price points. Due to the hard work of our highly skilled 
employees, our member firms, and the Securities and Exchange 
Commission, I am glad to report that the decimalization was 
accomplished without incident.
    As the engine of the new economy, Nasdaq is dynamic and is 
adjusting to changing market realities in order to better serve 
our listed companies, member firms, and investors. As you may 
know, Nasdaq applied to the Securities and Exchange Commission 
to become a registered national securities exchange in November 
of last year. We expect the SEC to publish our application for 
public comment in the Federal Register in the immediate future, 
and we are hopeful for a speedy approval at the end of the 
comment period. This process will facilitate final separation 
of Nasdaq from the NASD, lead to our ability to access the 
capital necessary for our Exchange to invest in new technology 
in order to remain a competitor in the world capital markets.
    I would now like to share with you our experience with 
decimalization. Again, I caution these initial trends are 
observed through a fast-track analysis. The three most 
important points I wish to share with you today are: First, 
Nasdaq's transition from fractions to decimals was smooth and 
seamless. To achieve today's results in a 5 week period, 
virtually every computer system within Nasdaq was changed. A 
similar effort took place among Nasdaq broker-dealers. This 
followed two pilots of decimalization in March of this year. On 
April 9, all remaining Nasdaq-listed securities began to be 
quoted in decimals. Thus, Nasdaq has successfully completed the 
full conversion to decimals in approximately 1 month. Nasdaq 
has been carefully monitoring the impact of decimalization both 
through our on-line surveillance and market operations group 
and by gathering and analyzing data for the 2 week period prior 
to decimalization and the period following decimalization.
    I would like to add that Nasdaq during all of this set a 
new share volume record only 7 days after full conversion to 
decimals of approximately 3.2 billion shares, and was able to 
handle that volume without incident.
    The second major observation we have is Nasdaq's market has 
seen a dramatic decrease in spreads. As expected, quoted 
spreads declined substantially for most stocks. Quoted spreads 
on average decreased by 51 percent. Our most active stocks saw 
a 71 percent spread decline. Many of Nasdaq's well-known and 
widely held stocks, such as Cisco, Dell, Intel, Microsoft, and 
others have now quoted spreads of one cent. Similarly, 
effective spreads declined for all stock groups by an average 
of 46 percent. This is in addition to the 30 percent decline 
seen following the order handling rules and move to \1/16\ in 
1997.
    The third and last observation is that there is no evidence 
on our market, to date, that the institutional investors are 
bearing the burden of any significant cost-shifting.
    We looked at large trades to see if decimalization thinned-
out the market and caused effective spreads for large 
institutional trades to increase. Our preliminary evidence is 
that they did not.
    One issue that has caused significant controversy within 
the industry but not in the Nasdaq market with a shift to 
decimals was pennying. On this issue it is useful to recognize 
that the advantages allowed by Nasdaq's market structure of a 
hybrid market with electronic communications network and 
competing dealers have not to date experienced a pennying issue 
in our market.
    We also believe competing market makers and ECN's will 
continue to provide a market environment that discourages 
unfortunate behavior. In fact, it is important to note that 
Nasdaq has been trading in pennies prior to April 9, 2001. 
Decimalization for Nasdaq was an issue of quoting in pennies.
    Overall, the implementation has been seamless. It is still 
a work in progress. We expect to continue to report our 
progress to you, the industry, and to the SEC.
    As more time passes, we could see the results change over 
time. We plan to continue to conduct our final detailed 
analysis for all three phases of decimalization as the SEC is 
requiring soon. We are committed to keeping you apprised of any 
future developments.
    Thank you.
    Senator Enzi. Ms. Kinney.

                STATEMENT OF CATHERINE R. KINNEY

                 GROUP EXECUTIVE VICE PRESIDENT

                    NEW YORK STOCK EXCHANGE

    Ms. Kinney. Chairman Enzi and Senator Corzine, my name is 
Catherine Kinney and I am a Group Executive Vice President at 
the New York Stock Exchange. And I am very pleased to be here 
today to relate some of the preliminary results of decimal 
trading.
    Decimalization has been one of the most important 
occurrences 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 this conversion process. The benefits of decimal 
trading have been realized, but the shift to a minimum price 
variation, or MPV, of one penny has created some difficulties. 
The New York Stock Exchange is already taking steps to remedy 
some of these detrimental effects. In this regard, we urge that 
the MPV be no less than one cent and that it 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.
    The Exchange is proud that our conversion to decimals was 
accomplished well ahead of the SEC's deadline without any 
systems or capacity problems. Most of our decimal conversion 
costs were incurred simultaneously with Y2K system conversions 
and cost about $30 million.
    The Exchange launched decimal trading with a pilot project 
of seven stocks in August 2000. Stocks in the pilot were priced 
in dollars and cents instead of fractions, and the minimum 
pricing increment was one penny instead of \1/16\ of a dollar. 
The pilot was extended to an additional 57 stocks in September 
and 94 stocks on December 4. The entire floor was converted on 
January 29, 2001, which was 2 months ahead of the SEC's 
deadline of April 9.
    We are confident that the conversion to decimal pricing has 
accomplished important public policy goals. It has certainly 
brought the U.S. markets into conformity with the quoting and 
trading systems that are used around the world. This will help 
the U.S. equity markets to expand their foreign listings, make 
us more competitive in trading with foreign markets, and 
certainly will facilitate the globalization of equity markets.
    Our preliminary analysis of conversion to decimal pricing 
indicates that, on balance, the penny increment has been good 
for some small retail investors. Stock prices in decimals are 
certainly more understandable. Over the last decade, direct 
share ownership by individual investors has certainly 
increased, and decimal prices will encourage this trend by 
breaking down a barrier to understanding the markets.
    Spreads have been reduced by approximately 37 percent and 
price improvement has been significantly increased, 
particularly for smaller orders. On the other hand, the one-
cent MPV has significantly impacted institutional investors. It 
is premature to draw any sweeping conclusions, but we have 
observed some trends that I would like to 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 reduced depth 
at the NYSE quote or the best bid and offer. They have 
experienced a lack of transparency of depth or liquidity 
outside the best bid and offer. And they have experienced an 
increased number of execution reports, that is, the number of 
transactions that are necessary to fill an order. These market 
participants are a very important part of our liquidity.
    The impact on institutional investors is an inevitable 
outgrowth of the decrease in the minimum price variation from 
6\1/4\ 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 liquidity 
that they require.
    Our research to date shows a significant 67 percent 
decrease in the number of shares available at the published 
NYSE quote. While true liquidity--that is, actual interest from 
all sources--available may not have been significantly 
impaired, there is a significant impairment of transparency.
    We have acted to address the transparency concerns of the 
institutional investor. The Exchange as you have heard this 
morning, has initiated two changes to permit dissemination of 
depth indications and depth quotes in our listed securities. 
These initiatives are the first in a series of actions that the 
Exchange will implement to improve transparency and 
communication of market depth in a decimal trading environment.
    Next month, we will also put forward an initiative called 
Open Book, and we have certainly expanded the use of hand-held 
terminals to brokers on our trading floor. In addition, we have 
formed an Advisory Committee on Decimalization to review 
decimal trading at the Exchange and to make recommendations.
    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 trading. The SEC has 
further requested all markets to submit by November 4 proposed 
rule changes establishing their individual choice by markets of 
the 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. In addition, the 
problems that institutional investors have faced in trading at 
an MPV of one cent would be exponentially increased if the 
markets were permitted to quote and trade in increments of less 
than one cent.
    I appreciate the opportunity to testify here today, and I 
would be pleased to answer any questions.
    Senator Enzi. Thank you very much.
    Mr. Pasternak.

               STATEMENT OF KENNETH D. PASTERNAK

              CHAIRMAN AND CHIEF EXECUTIVE OFFICER

                   KNIGHT TRADING GROUP, INC.

    Mr. Pasternak. Chairman Enzi, Senator Corzine, good 
morning. Thank you for this opportunity to testify today about 
the impact of trading in decimals. My name is Kenny Pasternak. 
I am Chairman, CEO, and President and Co-Founder of Knight 
Trading Group, the world's largest wholesale market maker for 
shares of both Nasdaq and non-Nasdaq equities.
    Knight Trading Group supports decimalization. By making 
stock prices easier to understand, decimalization encourages 
market participation and therefore benefits everyone.
    The U.S. stock markets recently adopted decimalized trading 
in the belief that it would narrow spreads and lead to less 
costly order execution. There is no doubt that spreads have 
fallen. In many instances, order execution has become more 
costly, not less. My purpose today is to focus this 
Subcommittee's attention on this issue.
    It is important to know that the introduction of 
decimalized pricing is not itself responsible for the narrowing 
of spreads. Rather, spreads have narrowed as a result of the 
decision by major market centers to reduce their minimum price 
variation--sometimes called MPV--to a single penny.
    Today's one-penny MPV has reduced price discovery, 
diminished liquidity, and increased the level of trading 
activity required to execute an entire order in many instances. 
No market participant has an incentive to quote size, as others 
can easily coopt that information and trade ahead by as little 
as one penny. While such problems were once experienced only by 
institutional investors, they are now affecting increasing 
numbers of individual investors as well.
    The one-penny MPV is, in many circumstances, too small. In 
my view, the most important issue for this Subcommittee's 
consideration is how to encourage the markets to arrive at the 
correct MPV for a given set of circumstances. This issue is 
vital to the depth, liquidity, and overall strength of our 
markets.
    Preliminary data suggests that, even for retail-sized 
orders, trading outside the spread has increased dramatically. 
The price discovery process has been impeded because the 
displayed depth on Nasdaq has also declined to approximately 
one-third of what it was before the transition to trading in 
decimals began. Meanwhile, we see that more and more investors 
feel compelled to break down their buy and sell orders into 
smaller lots in order to achieve more control over their 
executions. Trades generally have increased in number, but have 
declined substantially in size.
    In addition, the one-penny MPV has occasioned a significant 
decline in the average number of market participants at the 
inside quote. In other words, those who provide enhanced 
liquidity to the markets are now committing less capital for 
the execution of individual investor trades than they did 
before the one-penny MPV.
    Those who proactively provide enhanced liquidity constitute 
a large and highly competitive industry that is absolutely 
essential to the efficient operation of the markets. They often 
provide liquidity automatically in amounts considerably larger 
than the NBBO. This automatic execution feature expands as the 
MPV increases and shrinks as the MPV decreases.
    Presently, because of the one-penny MPV, many retail 
investors are paying more as the nature of executions changes 
from fast and complete to slow and fragmented. During the month 
of January, Knight Securities alone provided liquidity above 
the National Best Bid and Offer size level in excess of 179 
million shares. Without our enhanced liquidity, we estimate 
conservatively that investors would have paid nearly $4 million 
additional in execution costs.
    With the advent of the one-penny MPV, we and our 
competitors are providing enhanced liquidity in fewer 
instances. Whereas, we previously provided instantaneous, 
automatic execution at the NBBO price for any order of up to 
2,000 shares, we now reserve automatic execution for much 
smaller orders. And in many instances, we do not offer 
automatic execution no matter how small the order. This decline 
in availability of enhanced liquidity for Nasdaq stocks, 
coupled with the lower average quoted size, translates into 
slower and more fragmented executions--and ultimately, higher 
costs for individual investors.
    In the listed markets, what we are seeing is a pronounced 
increase in a number of ITS trade-throughs. This means that the 
investor may actually receive a price dis-improvement.
    During the first 6 trading days in February 2001, when 
decimal trading was introduced in all listed stocks, Knight 
Capital Markets experienced an average of more than 2,500 
trade-throughs per day by NYSE members, a more than four-fold 
increase over the predecimalized period.
    Before investors can realize the full benefits of 
decimalization, including cheaper order execution, Congress, 
the SEC, and the major market centers must address the negative 
consequences of narrowing spreads. Some of the blame can be 
traced to outdated rules and regulations that were written for 
an era of fractional pricing and substantially larger MPV's.
    I have addressed the most important of these issues in my 
written testimony. The implementation of trading in decimals 
has made the markets more accessible to investors, but it has 
also led to a number of profound changes that diminish market 
liquidity, as well as the speed and efficiency with which 
investor orders are being executed.
    Only by recognizing and adapting to the changes occurring 
in the U.S. markets can we continue to protect the investor, 
strengthen market integrity, and maintain the position of 
leadership that our market enjoy globally.
    As this Subcommittee ponders the significant policy issues 
surrounding decimal pricing, my colleagues and I at Knight 
would welcome any opportunity to contribute further to the 
discussion.
    Thank you.
    Senator Enzi. Thank you.
    Mr. Kittell.

                 STATEMENT OF DONALD D. KITTELL

                    EXECUTIVE VICE PRESIDENT

                SECURITIES INDUSTRY ASSOCIATION

    Mr. Kittell. Chairman Enzi, Senator Corzine, thank you very 
much for the opportunity to speak on behalf of the Securities 
Industry Association today.
    The SIA has worked for over 3 years with securities firms, 
the equities and options exchanges and Nasdaq, clearance and 
settlement organizations, service bureaus, market data vendors, 
the SEC, the Department of Justice, the General Accounting 
Office, a group of over 500 diverse organizations to convert 
the U.S. markets to decimals. We estimate that the conversion 
cost the industry approximately $1 billion, of which about $600 
million we attribute to increases in capacity.
    The operational aspects of the conversion were completed 
without incident and I would particularly credit the leadership 
of the New York Stock Exchange, Nasdaq, as well as my 
colleagues testifying today, for that successful result.
    I have four observations.
    The first is that the conversion was a positive step for 
investors and for the securities industry. The language of 
decimals is easier to understand. The U.S. markets now speak 
the same language as markets around the world. The opportunity 
for competition between market participants has been increased. 
We eliminated two particularly aggravating problems--the cloud 
of suspicion that hung around fractional trading and the image 
of Spanish antiquity with references to pieces of eight both 
eliminated. SIA has not attempted to put a value on those 
qualitative benefits.
    Second, the conversion has presented a number of 
challenges. And I would just like to point out that those 
challenges were not caused by decimalization, per se, but by 
the reduction in the minimum price variation. That reduction in 
the basic unit of trading was 84 percent, a \1/16\ or 6\1/4\ 
cents down to a penny--84 percent. And that reduction increases 
the number of trading increments that market participants can 
use by more than 6 times. It would be akin to the U.S. Senate 
moving from 100 to 625 Senators to deal with the same set of 
issues.
    When we use the term decimalization, we are really talking 
about two subjects--the language of decimals itself and the 
reduction in the minimum price variation of 84 percent. That 
reduction impacts market mechanics by creating more quotes, 
more trades, more price movements for traders and systems to 
handle. Market screens display the same amount of data, but 
less information. And all else being equal, the trading process 
must work perhaps 15 to 20 percent harder to accommodate the 
same dollar result.
    The smaller trading increment also impacts trading rules, 
as you have heard, and these rules impact just about every kind 
of trade and just about every kind of participant in the 
market. The increments also impact market making economics by 
reducing the spread, which is one of the ways that market 
makers have traditionally been paid for their services. And 
that changes the behavior of market makers, as well as those 
who trade with them.
    Third, market participants will successfully resolve these 
issues, in our judgment, through competition, experience, 
debate, ingenuity, working with the SEC, in the same way that 
the industry has successfully resolved difficult issues in the 
past.
    Market mechanics issues are the easiest to resolve, such 
things as volume and better display mechanisms. Trading rule 
adjustments take longer and market-maker behavior issues will 
take longer still. We believe that the process of adjustment 
will be in front of us for many months.
    Finally, the SIA believes that the markets are functioning 
smoothly, having accomplished the conversion without incident. 
The quality of our markets is as high as it has ever been. 
Competition has never been healthier.
    The industry-wide operations and systems resources have 
moved on and are now focusing on reengineering the clearance 
and settlement system and other projects that will further 
strengthen the safety and soundness of the equity markets for 
all investors.
    Thank your for your attention and I would be happy to 
respond to questions.
    Senator Enzi. Thank you, Mr. Kittell.
    Mr. Jenkins.

         STATEMENT OF PETER JENKINS, MANAGING DIRECTOR

                 HEAD OF GLOBAL EQUITY TRADING

                   ZURICH SCUDDER INVESTMENTS

    Mr. Jenkins. Thank you, Mr. Chairman for this opportunity 
to testify on decimalization today. My name is Peter Jenkins. I 
serve as Managing Director and Head of Equity Trading at Zurich 
Scudder Investments. We manage $400 billion for both 
individuals and institutions.
    I am a trader and I have been a trader for 21 years. I 
spend a considerable amount of my personal time promoting 
market efficiency. Today, my goal for being here is to provide 
you with practical suggestions to achieve this.
    As a preliminary comment, I would like to point out that I 
strongly support the move to decimal pricing in the U.S. 
securities markets and the trading of securities in minimum 
increments of one penny. The move to smaller trading increments 
reduces the spread in securities, which will result in benefits 
to our shareholders. In addition, the implementation of 
decimalization has enabled the pricing of securities in the 
United States to conform with securities markets around the 
world. Most institutional traders, such as myself, are 
continually adjusting to this new trading environment and we 
are already seeing the development of competitive products to 
help us cope with this change.
    Some critics have contended that the problems that market 
participants are facing since the move to decimalization have 
arisen solely as a result of that move. I do not believe that 
is the case. Instead, I would suggest that many of those 
problems are the result of the underlying structure of the 
securities markets on which we trade. Decimalization has simply 
brought these longstanding issues to the forefront, thereby 
highlighting the urgency of addressing several unresolved 
market structure issues. These include the need for the display 
of meaningful depth a of limit orders by specialists and market 
makers; and the need for priority rules for ordered entered 
into the securities markets; and the need to address problems 
arising from the internalization of orders. I have long 
advocated that with the move to decimals, we need greater 
transparency and increased electronic access to the markets.
    I should note that most of the difficulties that I have 
faced since decimalization have occurred while trading on the 
New York Stock Exchange. In contrast, we have had few such 
problems when trading securities on the Nasdaq Stock Market, 
due largely to the fact that electronic communications 
networks--ECN's--have offered efficient access and have allowed 
our traders to deal in smaller increments while at the same 
time have control over our order flow. But to the New York 
Stock Exchange's credit, they have taken some bold steps to 
address these emerging market issues, including the 
implementation of the ``Network New York Stock Exchange.'' 
However, since the implementation of decimalization on the New 
York Stock Exchange, the execution of large orders has actually 
been hampered by the reduced transparency of orders on the 
exchange limit order book.
    The dramatic increase in change of quotes in conjunction 
with increased instances of market participants stepping ahead 
of orders by increments of as little as a penny. The net effect 
has been for the institutional trader to lose control of his or 
her order flow, since no effective tools exist in the New York 
Stock Exchange listed market to reach the market efficiently. 
The ``upstairs'' trader does not have the time to negotiate 
trades as quotes change rapidly. This lack of control has led 
the upstairs trader to expose less to the market for fear of 
being ``front run'' for a penny. The result is an increasing 
amount of order flow has left the Exchange and has been 
directed to the alternative markets where institutions face 
less of a risk of having their orders stepped ahead, further 
fragmenting the listed market.
    These problems are not due to decimalization. They result 
from the fact that the New York Stock Exchange does not provide 
sufficient protection to the orders that I--and other 
institutional traders--utilize in trading larger amounts of 
stock. Today, when an electronic order is sent to the Exchange 
via Super Dot, the order is first exposed to the brokers on the 
floor who surround the specialists post prior to actually 
interacting with the Limit Order book. This technique is called 
``an attempt at price improvement.'' If an electronic order is 
small, it may in fact receive price improvement. If, on the 
other hand, the electronic order is large, an institutional 
order, the specialist may first allow the crowd to interact 
with the limit order prior to execution of the trade.
    These hidden orders in the ``pockets'' of the floor brokers 
gain standing. When an institution attempts to interact with 
limit orders on the book, most institutional traders feel this 
exposure to the crowd is unnecessary. If the upstairs trader 
were able to interact with the limit order directly without 
delay, floor brokers might be compelled to make instantaneous 
decisions and not use limit orders as options. In order to 
resolve these problems, institutions must have facilities for 
the automatic execution of large orders on the Exchange and the 
ability to trade large orders without subjecting these orders 
to the price improvement mechanisms.
    The New York Stock Exchange's new system, ``Institutional 
Xpress,'' does offer some solutions. But here's the problems 
with Xpress. Orders do not become expressible until it is on 
the best bid or offer for a time period of 30 seconds. This 
should be changed, to enhance efficiency, there should be no 
time limit. Institutional Xpress also requires that an order be 
at least 25,000 shares in size--this number is too high. 
Institutional Xpress should be able to react through the offer 
to get to the available liquidity pool.
    These large orders eligible for execution in that system 
should not be permitted to be represented by specialists to the 
crowd on the floor of the Exchange. The New York Stock Exchange 
has the opportunity to promote the placement of limit orders on 
the book by providing protection for, and rewarding the 
placement of, those orders and attracting order flow. These 
improvements that I suggest will serve to increase the depth 
and liquidity of the market. Greater transparency, along with 
greater liquidity, will benefit our investors to enabling them 
to get a more effective execution.
    In closing, I want to stress that I have worked with the 
New York Stock Exchange and other exchanges, as well as the 
Investment Company Institute directly for many years to voice 
my opinions, along with those of my competitors, on how best to 
provide institutions the liquidity we need to perform 
effectively on behalf of our clients' portfolios. These changes 
I suggest do not pose a threat to the New York Stock Exchange. 
In fact, these enhancements will offer the ability for both 
institutions and retail participants to transact more 
efficiently and at the best price.
    Thank you.
    Senator Enzi. Thank you.
    Mr. Fagenson.

                STATEMENT OF ROBERT B. FAGENSON

       VICE CHAIRMAN, VAN DER MOOLEN SPECIALISTS USA, LLC

     VICE CHAIRMAN, THE SPECIALIST ASSOCIATION OF THE NYSE

    Mr. Fagenson. Chairman Enzi, thank you for having me here 
today. I am Vice Chairman of Van der Moolen Specialists, one of 
the largest specialist firms on the floor of the Stock 
Exchange. I am also Vice Chairman of the Stock Exchange 
Specialist Association. So I am really here today representing 
the 480 men and women who are the specialists who do make the 
markets on the floor of the New York Stock Exchange.
    In 1997, the House introduced a bill called The Common 
Cents Pricing Act, and I had the opportunity to testify before 
the Subcommittee on Finance and Hazardous Materials, known as 
``cash and trash.'' We made several points there and, quite 
frankly, they have all come true.
    Reduced minimum trading increments from 12\1/2\ cents to 
6\1/4\ cents to a penny, are really down more than 90 percent 
now, and they are easier to understand. We said that this would 
reduce payment for order flow, which distorts the markets, 
where brokers send their orders to dealers who pay them for 
them, and perhaps, to a certain extent, ignore their fiduciary 
responsibility. This has been reduced, but it hasn't been 
eliminated.
    We felt this would hurt the regionals' ability to compete 
and, at this point, we think it has. And we fear that the 
Philadelphia Stock Exchange's equity business may, in fact, be 
in jeopardy.
    This would certainly create the ability for market 
participants to price improve or step ahead, depending upon the 
terminology you would use, for one penny. That certainly has 
happened, and also that the market would get cluttered with a 
tremendous number of meaningless flashing quotes and liquidity 
would be harder to find, although it was still there.
    Now all this has come to pass and it was not because we are 
geniuses and we had some crystal ball. But we do do this for a 
living and after 30 years on the floor, I can tell you that 
none of this was unexpected.
    We suffered a shock to the system, despite the fact that, 
technically, we were all prepared and the SEC made sure that we 
were, and the SRO's did a good job.
    It is the equivalent of traveling the same road to work 
every day for 30 years and it was 10 miles long, and there were 
eight traffic lights. And suddenly, one day, there were 16. It 
would be a bit more difficult, but it wouldn't be a 
tremendously noticeable change.
    Then one day, you woke up and there were a hundred lights 
on that same 10 mile stretch. Some were green, some were red, 
and some were yellow. So you had to stop some places and some 
places you did not, and every day, it changed.
    You knew the road really well and you were going to get to 
the other end, and it was a pretty safe travel. But it probably 
took a little longer, and the end and the time it would take 
was probably somewhat more obscured. And this, despite the fact 
that you were dealing in increments that were given to greater 
clarity.
    The participants all had to relearn how to do certain 
things. We had to develop new systems and the New York Stock 
Exchange has been moving aggressively to do that.
    What Cathy Kinney mentioned in terms of depth indications, 
depth conditions, the use of enhanced hand-held electronic 
devices to transmit information, and a look at the book that 
would allow investors to see a hundred price points, are 
certainly things that are going to move toward making this 
transition a lot smoother.
    It is almost like the equivalent of installing radar or 
sonar on your car as you traverse that road. It just lets you 
see out a little bit further so that you know exactly what is 
coming up.
    We are a lot busier on the floor. There are a tremendous 
number of quotes. A lot more trades per order. A 500- or a 
1,000-share order that used to get executed in one transaction, 
now may take two or three. These are just the realities that we 
have to deal with. Spreads are narrower, clearly, but the sizes 
at those reduced spreads are smaller.
    There are many inaccessible quotes that create tremendous 
frustrations, not just for Peter, but for all investors, large 
and small. I do not want you to confuse spreads with liquidity. 
Spreads have narrowed, but liquidity most likely is pretty much 
the same. It just is somewhat more obscured and a little bit 
harder to access. But we are working on that.
    Price discovery certainly has slowed. It is almost the 
equivalent of trying to buy a house and negotiating in $100 
increments. That may take a little bit longer than the way it 
is normally done.
    The ability to narrow quotes to a penny caused a tremendous 
upheaval. The phrase pennying was coined. Suddenly, there was a 
tremendous amount of finger-pointing. The specialists were 
blamed for all of it. We were unprepared for the result.
    But the statistics are proving that it is the professional 
traders, day traders, and floor brokers representing financial 
institutions that are in fact taking advantage of this ability 
to get a better price for their customer in increments as small 
as a penny.
    Yesterday, I learned of a new trading program that was 
developed to watch for quotes that are somewhat larger than 
average and automatically enter orders for a thousand or two 
thousand shares, a penny below or a penny above, just to try 
and take advantage of a perceived opportunity. But brokers are 
learning, both upstairs, off the floor, and downstairs, how to 
accommodate.
    If a market in Black Hills Power were 57 bid, offered at 57 
and 25 cents, and that became narrowed to 57.10 bid and 57.15 
offered, limit orders are now being entered to buy at prices 
higher than that lower offer, to bid through it and access the 
liquidity that is hidden above, and sell orders lower than the 
posted bid to access those buy orders below the posted bid, 
down to the point where that seller is willing to sell. Brokers 
on the floor are being given greater discretion, so they can 
access liquidity where they find it, and not having to run back 
to the phone every 2 minutes to ask for additional 
instructions.
    Mr. Chairman, we have the most powerful liquidity pool the 
world has ever known and it is intact and it is working just 
fine. We are still the envy of the world. We have increased the 
clarity and we are moving to solve our problems. But let us not 
forget why we did it.
    We did it to create a system that was more customer-
friendly. With trading increments reduced 90 percent and in 
dollars and cents, we are essentially there. But there is a 
great threat that looms. We could lose the very clarity that we 
have all fought so hard to try and create.
    If we permit subpenny trading to proliferate, trading in 
hundredths of a penny, in thousandths of a penny, we will 
destroy the ability to access liquidity. We went from saying 
that 10.125 was difficult to understand and 10.0625 is more 
difficult. So we said 10.05 sounds fine. Are we now to say that 
we bought something at 10.0237, is that better? When was the 
last time you walked into a supermarket and asked for 1.537 
pounds of ham?
    We have created a system that is efficient, effective, and 
understandable. Do we really want to create the equivalent of 
an impressionist art auction where bids go up a hundred dollars 
at a time? The buyers and sellers would be dead before the 
auction is over. Public confidence is hard to build and easy to 
destroy. We have to continue to design our systems for 
investors, not for practitioners.
    Just because we can do it, doesn't mean we ought to do it. 
And our industry, sometimes has acted in the reverse. As we 
look at rules such as the short-selling rule, let us take a 
hard look. But let us not forget that issuers and the public 
like some of these and before we change them, let us make sure 
we get their opinions.
    Subpenny trading can undo all the good we have 
accomplished. We call on you to go past what the SEC would 
suggest, which is study of this issue, and pass legislation 
that prevents the minimum increment nationally from moving 
below a penny unless we all decide that it is the right thing 
to do.
    The road to work may take a little bit longer to get there 
under certain circumstances, but let us not risk creating a 
gridlock that destroys the system we have worked so hard to 
build that we cannot undo.
    Thank you.
    Senator Enzi. Thank you very much.
    I want to thank all of you for your excellent testimony, 
not only the great job you did of convincing and summarizing 
here, but also the more extensive testimony. From my 
standpoint, I appreciate the way that you kept it simple and 
clear. Many of us do not have the depth of understanding or 
experience that you have acquired in your years of dealing with 
this. And, of course, one of our tasks, is to take what you 
told us and put it in terms that our constituents can 
understand, who are often confused and sometimes upset when 
they are talking to us. So I do appreciate your effort and the 
tremendous job that you did.
    To start the questioning, do any of you who spoke at the 
beginning have anything that you would like to comment on as a 
result of what has been said? And then those who testified 
later can say something about what they are saying now. Are 
there any additional comments based on the additional 
testimony?
    [No response.]
    I saw some note-taking up there at the desk, so I thought 
there might be.
    One of the reasons that we are holding this hearing today 
is 
because there have been numerous complaints about orders, 
particularly large orders, being stepped ahead by specialists 
and floor brokers. I do realize that there is the flip side to 
that, where there is some receiving of price improvement. Can 
you tell me what this effect is going to have on the small 
investor. Anyone?
    Mr. Fagenson. Well, the small investor who is buying in 
100-, 200-, 300-share lots has probably benefited the most from 
the change to decimal pricing because those small quotes that 
are created either by computer programs or other retail orders 
are usually in the size that the smaller investor is buying or 
selling. And at that narrower spread, they are probably saving 
some money.
    The greater frustration comes in for institutional 
investors such as Peter Jenkins, who has to deal in 100,000-, 
200,000-, and 500,000-share lots, and how do they find that 
liquidity? And that has become somewhat more of a task.
    So the small investor probably is having a better time and 
is probably reaping the greatest benefit. But once you get 
above that 200- or 300-share lot, it becomes a lot less clear. 
And in fact, they may be paying more in certain circumstances.
    Mr. Jenkins. I would add one thing. Zurich Scudder manages 
mutual funds and we have to remember that we represent 
thousands of individual retail mutual fund shareholders. My 
costs, if they are increasing, are affecting the retail. We 
need not forget that. It is not only the individual that comes 
direct to the 
Exchanges, the retail broker, but also the mutual fund 
shareholders as well.
    Senator Enzi. Excellent point. Anyone else?
    Mr. Pasternak.
    Mr. Pasternak. I think, just to take you back in history to 
illustrate, about 5 years ago, an individual investor who was 
trading on-line, let us say at the birth of the Internet in 
1995, he could buy 5,000 shares of virtually any Nasdaq stock, 
for instance, at the NBBO--the National Best Bid and Offer--the 
spread was generally an eighth or better or wider, for about 
$40.
    By about 1998, 1999, the price of that transaction had gone 
down to about $9 or $10 on the commission side. But the auto-
exsize had gone down to 2,000.
    Just to show you the tenuous balance between that 
proposition, over 95 percent of all orders were still 
automatically executing. And generally speaking, depending on 
how you define individual investor orders, a large proportion--
I do not have a stat right here--but I would say at least 90 
percent of all investors, individual investors, units of 
trading, are 2,000 shares or less meaning the marketplace was 
providing liquidity at the national best bid and offer the vast 
majority of the time. Today, under decimal pricing, that is 
occurring in our environment less than 50 percent of the time.
    I think Mr. Jenkins made a statement about the NBBO having 
some relevance in two cases. In the case, to make an assessment 
of how to proceed with a strategy to trade. And second, from a 
small individual investor. I would define it as 2,000 shares or 
less.
    Should there be a sense, a high sense of confidence that I 
can buy or sell, and even lower that to 1,000 shares of 
virtually any security in the United States at a price that I 
am seeing? If that sense of confidence is not there, then in 
fact what use is a pricing stream that includes a National Best 
Bid and Offer if most Americans cannot effect the transaction 
at that price?
    Senator Enzi. Mr. Campbell.
    Mr. Campbell. It is clear that in terms of the display 
depth on Nasdaq is about one-third of what it was in a 16th 
environment.
    The real question is, moving from 6\1/4\ pennies and then 
putting it in comparison to penny increments as opposed to 
16th, is the depth through that roughly the equivalent of what 
it was when it was in the 16th increment? Having been at this 
for 7 weeks, and having our display depth about a third of what 
it was prior in a fraction environment, I think right now, it 
is still premature for us to be able to come out and say, okay, 
this is exactly what is happening, and watching it migrate to 
some point in time where we really have statistical evidence as 
opposed to anecdotal.
    Senator Enzi. Mr. Fagenson.
    Mr. Fagenson. Mr. Chairman, historically, whenever we have 
increased the flow of information to investors, the market has 
grown. Whenever we have enhanced the quality of the 
information, the market has grown.
    The challenge is to make sure that we can have investors 
see not just the NBBO, but where liquidity resides. And we are 
moving in that direction by opening up the specialist book and 
by offering these depth indicators.
    That is really one of the keys. And in terms of 
Institutional Xpress, a system that Peter spent some time 
explaining, I would only say, if you understand it now, you 
ought to come to the New York Stock Exchange and take over 
because it is a complex system, and I was one of the people who 
helped design it and I still find it complex. But we did design 
it and we continue to enhance it, and we will, to give just the 
type of institutional access that Peter is talking about. And 
hopefully, over time, it will prove to be a system that works 
well. We want all investors, small and large, to have the best 
information. And the systems that provide that will continue to 
serve to expand the market.
    Ms. Kinney. Chairman Enzi, I think one of the issues that 
we raised in our testimony and one that is important to the 
Exchange is this issue of ensuring that both Congress and the 
SEC look at the issue of the MPV and not allow the minimum 
price variation to go below a penny. I think a number of the 
issues that have been raised here, whether it is reduced depth 
or whether it is reduced transparency, will all be exacerbated 
if the markets go below one penny as the minimum price 
variation.
    We would all agree here that individual investors who are 
buying 500 shares of IBM, or those that are buying 500 shares 
of Microsoft, are certainly getting better prices, when you 
look at what is driving the markets and the institutional 
interest in the markets, as well as individuals who are buying 
larger numbers of shares, you have to be concerned about some 
of the impacts that you have seen. And they certainly are 
impacts that we have seen before.
    A study has just come out by two economists looking back 
over the experience of moving from eighths to sixteenths. And 
they have concluded that simply having spreads narrow is not a 
good indicator of cost of execution. We just draw that to your 
attention as well and try to balance this issue across a 
variety of investors who are involved in the markets.
    Senator Enzi. Thank you.
    One of the things that Congress does is step in the middle 
of things occasionally. The purpose of this hearing was not to 
do that. It was to get some very basic information on a system 
that changed relatively recently--very recently--to see if any 
problems were cropping up yet that we would begin to hear 
about. Of course, we would hope that you, in cooperation with 
the SEC, would make the necessary changes and it wouldn't ever 
become a legislative responsibility.
    In regard to the SEC, does the decimal implementation 
change the necessity of certain regulations, such as the short-
sale rule or the trade-through rule? Are there things pending 
there now that do not need to be done and some that do need to 
be done that maybe are not being considered?
    Mr. Fagenson.
    Mr. Fagenson. I think we have to make sure that we do not 
think about every stock trading the same way. Stocks trade 
differently. Your hundred most active stocks are going to trade 
far differently than your hundred least active stocks.
    There are all sorts of variations in the middle. And while 
eliminating the short-sale rule in your top one hundred stocks 
might crate additional liquidity, it might create havoc and 
market manipulation in less liquid stocks. So this is really an 
issue that I think requires tremendous study.
    If you ask issuers and you ask small customers whether they 
take comfort in a rule such as the short-sale rule, I think, 
universally, they would probably say yes. But before we upset 
that delicate balance, I think we have to make sure that the 
perceived benefit is really there before we destroy this 
element of public confidence that I think is an important piece 
of the market framework.
    Senator Enzi. Mr. Campbell.
    Mr. Campbell. Mr. Chairman, we have submitted rules to 
reflect the new structure and the trading environment that we 
are in to address the changes brought about by decimalization.
    My only concern is that the SEC opines on the short-sale 
rule prior to an adequate time to evaluate as we are doing our 
new 
experience with about 7 weeks of history behind us in a decimal 
environment. Our concern is that it is well thought out, that 
it is adequately discussed, and the empirical evidence is there 
to be able to make an important judgment call as we start 
modifying the rules in a new market environment.
    I do agree that there are some very important attributes of 
short-sale rule that are very important to a lot of people.
    Our only concern is that we have the right debate with the 
right information at the appropriate time when the empirical 
evidence is available, and it is not today.
    Senator Enzi. Anyone else wish to comment on that?
    [No response.]
    The foreign markets have been decimalized for a longer time 
than we have, they have probably been dealing with some of the 
problems that we have discussed, such as the shrinking limit 
orders and stepping in front. How are they handling it? Or are 
they worrying about it at all?
    Mr. Jenkins.
    Mr. Jenkins. I think in the foreign markets, they have 
stressed time and price priority and connectivity. And I think 
that is the way they are dealing with a lot of these problems.
    Clearly, they have their problems as well. But priority of 
order placement is important, or a little bit more important, 
in the international markets.
    Mr. Kittell. Also, in the case of some international 
markets, the minimum price variation varies by the price of the 
stock.
    So that a $100 stock would have a higher minimum price 
variation than a $10 stock. And there will be a schedule of 
four or five minimum price variations up and down the price 
scale.
    We have that in the United States here in the case of 
options trading, where the options priced below $3 trade at the 
moment in 5 cent increments, and over $3 trade in 10 cent 
increments.
    Mr. Pasternak. Just two comments. We do have operations in 
Europe and Japan and we are active in those markets. We do have 
a perspective--it is a real-time perspective. You could make a 
few observations about the foreign markets.
    First is that the individual investor is not as far along 
as he is in the United States. So there is still a very heavily 
institutional market that is in almost every market in the 
world.
    Second, that their markets are behind our markets and we 
are the envy of every market in the world when it comes to 
liquidity, price discovery, and what I call liquidity provider 
participation. And finding that sweet spot between rewarding 
price discovery--I think Mr. Jenkins has an excellent point 
about incentivizing and eliminating people from coopting your 
information and rewarding you properly.
    Markets have to take that head on and find a balance 
between that and people who are bringing liquidity, capital and 
expertise to the market, liquidating both block trades for 
institutions, providing knowledge for institutions, and 
liquidating individual investor transactions. The foreign 
markets have not reconciled that and there is no culture 
whatsoever of capital commitment and immediacy for individual 
investors in virtually every market in the world, except for 
ours. As we look forward, we should protect what we have and 
keep refining it, but not to think that our markets are second 
to each, but certainly respect innovation, even if it comes 
from around the world.
    Mr. Fagenson. We make markets in Germany, Great Britain, 
Amsterdam and here in the States. We were the largest 
specialist on the Amsterdam Stock Exchange for many, many 
years. We still are, although they are doing away with the 
specialist system. These markets are far smaller than we are. 
As Ken just said, they take absolutely no notice or concern for 
the individual investor.
    I mean, the big bang in London was the sound of the small 
investor getting whacked over the head. They bifurcated that 
market into wholesale and retail so that they could hide what 
they were doing in size transactions and in not any way 
demonstrate what the true price was. Price discovery went on 
behind closed doors. So they have been doing it longer, but 
that is just made them more expert at hiding things.
    Senator Enzi. Mr. Campbell.
    Mr. Campbell. Mr. Chairman, I think the one thing that 
everybody at this panel has really pushed very hard in 
everything the capital markets, the United States, does today 
is transparency.
    Most foreign markets have solved their decimal issues by 
lack of transparency. And as we continue to balance as much 
information that we can provide for the benefit of the 
investor, that is part of what we are all trying to do in the 
most sincere way we know how. Most foreign markets have gone 
the other way. You cannot see what the problems are because 
they do not allow you to.
    Senator Enzi. Anyone else?
    [No response.]
    I am glad that I asked that last question because it is not 
often in the Banking Committee when we are dealing with 
securities or accounting issues and those sorts of things, that 
you get that feeling of patriotism, and how great it is in the 
United States.
    [Laughter.]
    Every one of you reflected how we have it better in the 
United States. Of course, that is what this Committee wants to 
make sure happens, that that same thing continues as we become 
kind of a clearinghouse for complaints, mostly from 
constituents.
    I think the view of the Committee is that the 
decimalization has gone well and that life is good in the 
United States. Some of the things that you mentioned may be 
more of an effect of the economy than the decimalization 
process. And we want to keep a careful eye on that.
    I do have a series of questions for each of you. But I will 
submit those to you and would appreciate your answers. And 
then, when I get the answers, I will circulate both the 
questions and the answers to my colleagues. And we will be 
doing some summaries of what you said and emphasizing those a 
little bit, too. Of course, they will be from my perspective 
because I am the one here.
    [Laughter.]
    So I do appreciate your participation today and all of your 
help. We will be calling on you again. Thank you very much.
    Ms. Kinney. Thank you very much.
    Mr. Campbell. Thank you.
    Mr. Jenkins. Thank you very much.
    Senator Enzi. The hearing is adjourned.
    [Whereupon, at 11:20 a.m., the hearing was adjourned.]
    [Prepared statements and response to written questions for 
the record follow:]
                  PREPARED STATEMENT OF LAURA S. UNGER
        Acting Chairman, U.S. Securities and Exchange Commission
                              May 24, 2001
    Chairman Enzi, Ranking Member Dodd, and Members of the 
Subcommittee:
    I am pleased to testify today on behalf of the Securities and 
Exchange Commission (``Commission'' or ``SEC'') concerning the recent 
conversion of quotations in equity securities and options from 
fractional to decimal pricing and the effects that this change has had 
on market dynamics and trading behavior. I would particularly like to 
address not only the benefits of decimalization, but also some aspects 
of this historic change that could affect the transparency, liquidity, 
and fairness of our markets.
I. Introduction
    As you know, under Congress' leadership, over the past year the 
U.S. markets have moved from pricing shares in fractions to pricing 
shares in dollars and cents--the same pricing used in virtually all 
other aspects of the economy. The goal of decimalization was viewed as 
necessary to simplify pricing for investors and to make our markets 
more competitive internationally. Many proponents of decimalization 
also hoped that decimal prices would ultimately reduce trading costs 
for investors by, among other things, permitting quotation spreads (the 
difference between the highest bid quotation and the lowest offer 
quotation) to narrow from the \1/16\ minimum increment that was 
standard in the fractional environment.
    Over the last year, the Commission has sought to ensure that the 
conversion to decimal pricing was accomplished in as rapid but orderly 
a manner as possible. On June 8, 2000, we issued an order directing the 
securities exchanges and the Nasdaq Stock Market (``Nasdaq'') to phase-
in decimal pricing beginning no later than September 5, 2000, and 
ending no later than April 9, 2001.\1\ As a result of the careful 
planning, preparation, and coordination among regulators, the markets, 
clearing agencies, vendors, and the securities industry, I am able to 
report that the phasing-in of decimal pricing was completed on schedule 
and without significant operational problems or trading disruptions.
---------------------------------------------------------------------------
    \1\ See Securities Exchange Act Release No. 42914 (June 8, 2000), 
65 FR 38010 (June 19, 2000).
---------------------------------------------------------------------------
    While comprehensive analyses of the market effects of 
decimalization are not yet available, preliminary reviews by the 
Commission's Office of Economic Analysis (``OEA'') and Nasdaq indicate 
that at least some of the anticipated benefits of decimalization, such 
as the significant narrowing of quotation spreads, are already evident. 
For example, OEA estimates that, from December 2000 to March 2001, 
quotation spreads in securities listed on the New York Stock Exchange 
(``NYSE'') narrowed an average of 37 percent, and effective spreads 
narrowed 15 percent.\2\ An even more dramatic reduction in quotation 
spreads was observed in Nasdaq securities, with spreads narrowing an 
average of 50 percent following decimalization, and effective spreads 
narrowing almost as much. While it is difficult, at this time, to 
formulate accurate estimates of the extent to which investors may have 
benefited from decimalization, the overall narrowing of spreads makes 
it likely that investors entering small orders that are executed at or 
within the quotes have experienced reduced trading costs.
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    \2\ The effective spread measures the cost of trading by comparing 
the execution price of a trade with the current mid-point of the quoted 
spread. Since trades sometimes occur at prices that are better than the 
posted quotes, the effective spread measure captures this ``improved 
pricing.''
---------------------------------------------------------------------------
    In addition, preliminary studies by Nasdaq indicate that, despite 
the concerns previously raised by some market commentators, decimal 
pricing has not expanded quotation traffic or exacerbated capacity 
demands to the extent anticipated. Although there is some evidence that 
the number of quotation updates has increased, the fears that 
decimalized quotes would cause reporting backlogs and outages appear to 
have been unfounded.
    Nevertheless, the Commission has long recognized that the shift 
from fractional to decimal prices had the potential to influence market 
dynamics and trading behavior in ways that could affect the 
transparency, liquidity, and fairness of the markets. When ordering the 
decimal conversion last June, therefore, the Commission required the 
markets to carefully phase-in this process in order to provide 
regulators and market participants opportunities to observe how 
decimalization worked in practice. The Commission hosted a roundtable 
on December 11, 2000 to solicit viewpoints on how the early phases of 
decimalization were affecting markets and trading. Moreover, our June 
8, 2000 decimals order required the markets to conduct their own 
studies within a few months of the full implementation of decimal 
pricing on April 9, 2001 that would analyze how the conversion had 
affected systems capacity, liquidity, and trading behavior. In view of 
the complexity of some of the issues that have been raised concerning 
decimal pricing, the Commission has extended the deadline for the 
markets' studies to September 10, 2001.\3\ In the meantime, we are 
continuing to work with the markets and market participants to identify 
any aspects of decimalization that might compromise the fair and 
orderly operation of the securities markets.
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    \3\ The difficulties inherent in conducting useful analyses of the 
effects of decimalization in such a short time frame were also 
discussed in a letter from the American Stock Exchange (``Amex'') 
requesting an extension of the June 8, 2001 deadline for decimalization 
studies. See letter to Annette Nazareth, Director, Division of Market 
Regulation, from Peter Quick, Amex President, dated May 9, 2001. The 
Commission has decided to extend the study deadline not only for the 
Amex, but also for the other securities exchanges and the NASD.
---------------------------------------------------------------------------
    Today, I would like to focus on how decimalization has affected 
market transparency and liquidity, as well as key investor protection 
and market integrity rules of the Commission and the self-regulatory 
organizations (``SRO's'').
II. Effects on Market Transparency and Liquidity
    Market transparency--the dissemination of meaningful quote and 
trade information--assists investors in making informed order entry 
decisions and enables broker-dealers to meet their best execution 
duties for their customer orders. Moreover, market transparency plays 
an essential role in linking dispersed markets and improving the price 
discovery, fairness, competitiveness, and attractiveness of U.S 
markets. Currently, the quotes and trade reports from all registered 
exchanges and Nasdaq are published on a consolidated basis to vendors, 
brokers, and customers worldwide.
    Decimal pricing presumably has enhanced the ability of investors to 
understand the consolidated quotations of competing market centers. 
Investors can now easily compare prices to buy and sell stocks in 
dollars and cents without having to deal with prices in fractions. 
Nevertheless, we recognize that, as the minimum quoting increment has 
narrowed to a penny, the market depth at any particular price level 
(that is, the number of shares available at the published bid or offer) 
has decreased as well. For example, OEA has estimated that quote sizes 
in NYSE-listed securities have been reduced an average of 60 percent 
since the conversion to decimals and preliminary analyses of Nasdaq 
securities show a 68 percent reduction in quote sizes. Some firms and 
institutional investors also have expressed concerns that the reduction 
in quoted market depth may be adversely affecting their ability to 
execute large orders.\4\ In particular, market participants have 
indicated that smaller trading and quoting increments have increased 
the risk of displaying limit orders, particularly larger limit orders, 
leading to a reduction in the amount of liquidity provided by such 
orders. In an effort to provide more information about available 
liquidity, the NYSE recently proposed, and the Commission approved on 
an accelerated basis, a rule to disseminate ``depth indications'' and 
``depth conditions'' to reflect market interest in a security below the 
published bid and above the published offer.\5\
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    \4\ See letter to Richard A. Grasso, Chairman, New York Stock 
Exchange, Inc., from Craig S. Tyle, General Counsel, Investment Company 
Institute, dated March 11, 2001.
    \5\ See Securities Exchange Act Release No. 44084 (March 16, 2001), 
66 FR 16307 (March 23, 2001) (NYSE Rule 60). The Commission's Advisory 
Committee on Market Information is also considering a range of market 
transparency issues.
---------------------------------------------------------------------------
    We recognize, however, that these measures alone are unlikely to 
address market participants' liquidity concerns in a decimal 
environment. We have asked the markets to evaluate these concerns in 
their reports to the Commission, and we will work with the markets and 
the securities industry to identify and address any negative effects 
from decimalization on overall market transparency and liquidity.
III. Investor Protection and Market Integrity
    We recognize that decimal pricing also raises a number of issues 
regarding vital investor protection and market integrity rules of the 
Commission and the SROs that depend on price changes or differentials. 
I will briefly mention two examples.
Customer Limit Order Protection Rules
    Investors use two main types of orders to buy securities: market 
orders and limit orders. When a customer uses a market order, a broker 
will execute the order in the market at the best price available. When 
a customer uses a limit order, a broker is required to obtain an 
execution at the limit price or better. By submitting a limit order, 
the customer competes for a better price than the market is offering, 
or limits the price that the investor will accept. As a result, limit 
orders provide liquidity to those who demand immediate execution. Limit 
orders are a very important source of price information and market 
liquidity in the equity markets. When customers submit limit orders, 
they are held by a specialist or market maker until the orders are 
executed, they expire, or are cancelled. Because they collect these 
limit orders submitted by customers, specialists and market makers may 
obtain informational and trading advantages. Commission and SRO rules 
protect customer limit orders by providing them with priority over 
specialist and market maker proprietary orders at the same price on the 
exchanges and on Nasdaq.\6\ However, specialists and market makers can 
``step ahead'' of customer limit orders by trading at a price better 
than the existing limit order.\7\
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    \6\ Exchange Act Rule 11a1-I (T) requires Exchange members to grant 
priority to any bid or offer at the same price for the account of a 
person who is not a member. NYSE Rule 92(b) prohibits NYSE members from 
trading for their own account at the same price as an unexecuted 
customer limit order. The NASD's Manning Rule similarly requires the 
execution of a customer limit order upon the execution of a proprietary 
trade at a price that would satisfy the customer limit order. See NASD 
IM-2110-2--Trading Ahead of Customer Limit Order.
    \7\ It should be noted that when a specialist or market maker 
``steps ahead'' of a limit order, it provides ``price improvement'' to 
the execution on the contra side of the trade. For example, assume that 
a customer limit order is sent to a specialist or market maker to buy 
100 shares of XYZ stock at $10 per share for a total of $1,000. The 
specialist or market maker may decide to ``step-ahead'' of the customer 
limit order and trade with a customer order to sell the security. While 
the customer buy order would remain unfilled in this situation, the 
customer sell order would receive a price from the specialist or market 
maker that is better than it would have received from an execution with 
the customer buy order.
---------------------------------------------------------------------------
    With some variations, the rules of the NYSE and the NASD require 
that a specialist or market maker who wants to ``step ahead'' of a 
customer limit order pay a price which is greater than the limit order 
by at least the minimum quoting increment.\8\ However, with the 
conversion to decimals, the minimum price increment has decreased from 
\1/16\, or 6.25 cents, to 1 cent. This means that it could be less 
costly for specialists, market makers, and possibly certain other 
market participants to profit from their knowledge of limit order flow 
by trading ahead of limit orders for only a penny a share.\9\ Public 
traders may defend themselves from such stepping ahead practices by 
using floor brokers to hide their orders, by breaking up their orders, 
and by switching to market order strategies from limit order 
strategies. These responses could increase transaction costs and reduce 
market transparency.
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    \8\ NYSE Rule 92(b) establishes a defacto ``stepping-ahead'' 
increment based on the NYSE's minimum trading and quoting increment. 
That increment is currently a penny for most securities. The NASD's 
Manning Interpretation requires market makers who want to trade ahead 
of customer limit orders to trade at a price $0.01 better than the 
customer limit order priced at or better than the inside market. For 
customer limit orders priced outside the inside market, a market maker 
must trade at a price at least equal to the next superior minimum 
quotation increment. See Securities Exchange Act Release No. 44165 
(April 6, 2001) 66 FR 19268 (order 
approving Nasdaq proposed rule change to the Manning Interpretation 
adopting a $0.01 price improvement standard for securities quoting in 
decimals.)
    \9\ For example, assume that a public limit order is entered to buy 
100 shares of XYZ stock at $10 per share for a total of $1,000. Under 
fractions, with a minimum price increment of \1/16\ a specialist or 
market maker could trade ahead of the customer buy order by executing 
at $10\1/16\ per share, for a total of $1,006.25. With the decimals 
minimum price increment of a penny, it is possible that the specialist 
or market maker could ``step-ahead'' of the customer order by paying 
$10.01 per share for a total cost of $1,001 to buy 100 shares, an 84 
percent reduction in the ``stepping-ahead'' cost.
---------------------------------------------------------------------------
    Since the commencement of decimals trading, numerous articles have 
appeared in the press that have raised concerns about increased 
stepping ahead activity. In addition, the NYSE held a meeting on 
February 16, 2001 with a cross-section of market participants to 
discuss several issues related to decimal trading--including ``stepping 
ahead.'' The NYSE reported after the meeting that while it believed 
that some of the problems associated with decimals may be behaviorally 
solved, some other issues might need to be addressed systemically, and 
has organized committees to examine these issues and develop possible 
solutions.
    The Commission currently is gathering information about the 
operation of these investor protection rules in the decimal 
environment, and will consider whether action is necessary to protect 
investors.
Short Sale Regulation
    A short sale is the sale of a security that the seller does not own 
or that the seller owns but does not deliver.\10\ In general, short 
selling is utilized to profit from an expected downward price movement, 
or to hedge the risk of a long position in the same security or in a 
related security.
---------------------------------------------------------------------------
    \10\ See Rule 3b-3 under the Exchange Act, 17 CFR 240.3b-3.
---------------------------------------------------------------------------
    Commission Rule 10a-1 is designed to restrict short selling in a 
declining market. The rule applies to short sales in any security 
registered on a national securities exchange, and uses a ``tick test,'' 
which means that a short sale generally must be at a price higher than 
the last reported sale for the security. \11\ The NASD also has a short 
sale rule for Nasdaq securities that requires a short sale to be 
effected at a price above the current bid in a declining market.\12\ In 
a decimals environment, where price differences between trades can be a 
penny or less, the question is: how much above the last sale or the bid 
must a short sale be?
---------------------------------------------------------------------------
    \11\ 17 CFR 240.10a-1.
    \12\ NASD Rule 3350 prohibits short sales by NASD members in NMS 
securities at or below the current best (inside) bid as shown on the 
Nasdaq screen when that bid is lower than the previous best (inside) 
bid (commonly referred to as the ``bid test''). Rule 3350 contains 
certain exemptions, including an exemption for qualified Nasdaq market 
makers, options market makers, and warrant market makers. The Rule also 
contains exceptions similar to those provided under Rule 10a-1.
---------------------------------------------------------------------------
    On March 2, 2001, the Commission took a step toward answering this 
question when we approved a change to the NASD short sale rule 
providing that a ``legal'' short sale must be executed at a price at 
least $0.01 above the current best bid.\13\ In approving this amendment 
on a one-year pilot basis, we noted that transactions based on very 
small price changes could undermine the operation of the short sale 
rules. While permitting a $0.01 increment standard for short sales 
during the initial stages of the conversion to decimal pricing, we 
required Nasdaq to submit a study analyzing the operation of the 
amended rule.\14\
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    \13\ See Securities Exchange Release No. 44030 (March 2, 2001) 66 
FR 14235 (March 9, 2001).
    \14\ The Nasdaq study is due on December 1, 2001.
---------------------------------------------------------------------------
    Essentially the same question arises in the context of the 
Commission's short sale rule. In addition to our ongoing review of the 
short sale rule, which was begun in our concept release in October 
1999,\15\ the Commission's staff is gathering data and is considering 
rule changes to address short selling in a decimals environment.
---------------------------------------------------------------------------
    \15\ Securities Exchange Release No. 42037 (October 20, 1999) 64 FR 
57996 (October 28, 1999).
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IV. Subpenny Trading
    Many of the regulatory issues that have arisen in a decimal 
environment may be exacerbated by the practice of trading at increments 
finer than $0.01, commonly referred to as subpenny trading. For years, 
some electronic communication networks (``ECN's'') and Nasdaq market 
makers have permitted trading in increments smaller than that displayed 
through the Nasdaq system. This practice has continued in the decimal 
environment, with approximately 4 to 6 percent of trades in Nasdaq 
securities executed in subpenny increments even though the quotations 
for these securities are at a penny increment. On April 6, 2001, the 
Commission approved, on a pilot basis, a rule filed by the NASD 
specifying the protections Nasdaq market makers must provide to 
customer limit orders priced in subpennies.\16\ As noted earlier, the 
NASD's Manning Interpretation requires the execution of a customer 
limit order held by a market maker if the market maker trades for its 
own account at a price that would satisfy the customer limit order.\17\ 
The market maker, however, can trade for its own account at a price 
better than the customer limit order and is not obligated to execute 
the limit order (so-called ``trading ahead''). The amendment to the 
Interpretation requires market makers who want to trade ahead of 
customer limit orders to trade at a price at least $0.01 better than 
the customer limit order priced at or better than (inside) the best 
displayed inside market. For customer limit orders priced outside the 
best displayed inside market, a market maker must trade at a price at 
least equal to the next superior minimum quotation increment. Because 
subpennies increase the concerns raised by decimal trading, the 
Commission needs to consider the impact of subpenny trading on market 
transparency and liquidity, as well as investor protection and market 
integrity rules.
---------------------------------------------------------------------------
    \16\ Securities Exchange Act Release No. 44165 (April 6, 2001), 66 
FR 19268. The Commission also approved on April 6, 2001, a pilot 
program setting forth protections that must be provided by specialists 
and market makers on the Chicago Stock Exchange(``CHX'') for customer 
subpenny orders in Nasdaq securities. Securities Exchange Act Release 
No. 44164 (April 6, 2001), 66 FR 19263 (April 13, 2001). The Nasdaq and 
CHX proposals were approved as pilot programs until July 9, 2001, 
during which time the markets will supply the Commission staff with 
monthly reports on their activity in subpenny increments.
    \17\ See text at n. 6, above; NASD IM-3220-2--Trading Ahead of 
Customer Limit Order.
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V. Conclusion
    The conversion to decimals went smoothly from an operational 
standpoint, thanks to the planning and cooperation among regulators, 
self-regulators, and the industry. Decimal trading has raised issues 
that must be carefully considered to ensure our markets remain 
transparent, liquid, and fair. As other market challenges have arisen 
over time, the Commission has embraced these challenges, working to 
adapt regulatory structures in a manner that will affirm investor 
confidence and help to lead our markets into the future. We believe 
that the conversion to decimals fosters these goals by simplifying 
pricing and making our markets more competitive internationally. We 
recognize, however, that there are some aspects of the effects of 
decimalization that still need to be considered thoroughly. I want to 
assure you that the Commission is working with the markets and the 
securities industry to address potential problems while preserving the 
benefits of decimalization. We appreciate the Subcommittee's continuing 
interest in this issue and the role it has played in helping to ensure 
a smooth transition to decimals.
    Thank you. 
    
    
     
    
     
    
               PREPARED STATEMENT OF J. PATRICK CAMPBELL
                   President, Nasdaq U.S. Markets and
            Chief Operating Officer, The Nasdaq Stock Market
                              May 24, 2001
Introduction
    Mr. Chairman and Members of the Subcommittee, I am Pat Campbell, 
President, Nasdaq U.S. Markets and Chief Operating Officer, The Nasdaq 
Stock Market. We welcome this opportunity to share with you our 
experience and insights into the recent conversion to decimal pricing 
on the Nasdaq Stock Market.
    As the world largest stock market by every measure other than 
aggregate market capitalization (for example, in terms of the number of 
listings, dollar volume, transaction volume and liquidity), ensuring 
that decimalization of the market was not disruptive to investors and 
the U.S. capital markets was our primary concern. Crucial to our job as 
the world's largest provider of stock quote information is maintaining 
the availability, integrity, and accessibility of this data. The 
estimates of increased computer system demands made switching to 
decimals a challenging project. One study projected a three-fold 
increase in quotation traffic. Decimalization takes the market from 16 
price points per dollar to 100 price points. Due to the hard work of 
our highly skilled employees, member firms and the Securities and 
Exchange Commission (SEC), I am glad to report that the decimalization 
was accomplished without incident.
    We are proud of the often-cited characterization of Nasdaq as the 
Engine of the New Economy. However, we are much more than that. Across 
the board, we have been the home to more IPO's than any other U.S. 
market, providing crucial access to capital for new companies of all 
sizes and types to grow. These companies create jobs and add vibrancy 
to local economies. The impact of these benefits are felt in every 
State.
    Nasdaq is dynamic and is adjusting to changing market realities in 
order to better serve our listed companies, member firms, and 
investors. As you may know, Nasdaq applied to the SEC to become a 
registered national securities exchange in November of last year. We 
expect the SEC to publish our application for public comment in the 
Federal Register in the immediate future, and we are hopeful for speedy 
approval of our application at the end of the comment period. This 
process will facilitate final separation of the Nasdaq from the NASD, 
lead to our ability to access the capital necessary for our Exchange to 
invest in new technology in order to remain a competitor in the world 
capital markets, and allow us to better serve our constituencies. In 
order to continue to be the preeminent global competitor, we have 
recently taken significant steps such as the March 27, 2001, 
acquisition of a majority interest in the pan-European Easdaq stock 
market, as well as the March 26, 2001, announcement of Nasdaq's 
partnership with the London International Financial Futures and Options 
Exchange to offer single stock futures in the United States. As you 
know, Nasdaq Japan, our undertaking with the Osaka Stock Exchange, is 
operational and is becoming an increasing presence in the Japanese 
equity market, particularly with respect to IPO's.
Early Analysis
    I would caution that the initial trends are observed through a 
fast-track analysis intended to get information to the Subcommittee as 
quickly as possible. The data has not yet been verified by independent 
analysis, but is instructive as an important benchmark for short-term 
analysis. It is preliminary and will be continuously revisited as we 
gain more experience with the new environment. The three most important 
points I wish to share with you today are:

          (1) Nasdaq's transition from fractions to decimals was smooth 
        and seamless;
          (2) Nasdaq's market has seen a dramatic decrease in spreads; 
        and
          (3) There is no evidence on our market, to date, that 
        institutional investors are bearing the burden of any 
        significant cost-shifting.
Nasdaq's Seamless Transition to Decimals
    To achieve today's results in a very compressed time frame, 
virtually every computer system within Nasdaq was changed. This 
included an upgrade of the Enterprise Wide Network, a change to Nasdaq 
Workstations to allow for the display of decimal information, 
replacement of front-end processors with a higher-capacity computer 
architecture that allows for quoting and matching of decimals trades, 
and upgrades to back-office batch processing systems that calculate 
indices, dividends, etc. A similar effort took place among Nasdaq 
broker-dealers that required them to assess and redesign their systems 
and business models. This followed the first two pilots of 
decimalization for 212 Nasdaq stocks and 3 OTC Bulletin 
Board' (OTCBB) securities in March 2001. On April 9, 2001, 
all remaining Nasdaq-listed securities began being quoted in a decimal 
format with a $0.01 minimum price increment (for example ``tick 
size''). Thus, Nasdaq has successfully completed the full conversion to 
decimal quoting and trading in approximately 1 month. Nasdaq has been 
carefully monitoring the impact of decimalization both through our on-
line surveillance and market operations group and by gathering and 
analyzing data for the 2 week period prior to decimalization and 
comparing it to the 2 week period following decimalization (March 26, 
2001-April 20, 2001). I would like to add that Nasdaq set a new share 
volume record only 7 days after full conversion to decimals--3.19 
billion shares--and was able to handle that volume without incident.
    Among the major concerns raised by conversion to decimals is the 
capacity impact on message traffic. There are two general classes of 
messages: quote updates disseminated by the various market centers and 
the Last Sale trade report disseminated by Nasdaq. We found that the 
number of quote updates for stocks increased by at least 12 percent 
after controlling for the day-to-day fluctuation in trading activity 
for the overall market. The Nasdaq systems have ample capacity to 
handle this increase.
    As expected, decimals did not significantly increase the overall 
market trading 
activity. On average, stocks experienced only a 5 percent increase in 
trades and a less than 1 percent increase in volume.
Dramatic Decrease in Spreads
    As expected, quoted bid-ask spreads declined substantially for most 
stocks. A quoted spread is an appropriate measure of costs for retail 
investors placing small market orders. All types of stocks saw dramatic 
decreases in quoted spreads; on average, the quoted spreads decreased 
by 51 percent. All else being equal, the decline was greater for more 
active and lower price securities--our most active stocks saw a 71 
percent spread decline. Many of Nasdaq's most well known and widely 
held stocks, such as Cisco, Dell, Intel and Microsoft and others, now 
have quoted spreads of one cent. Similarly, effective spreads (spreads 
that take into account actual trade prices) declined for all stock 
groups by an average of 46 percent. This is in addition to the 30 
percent decline seen following the order handling rules and move to 
sixteenths in 1997.
    Many people expected the intra-day volatility to increase as a 
result of decimalization, the frequent change of the inside quotes. We 
use three measures of intraday volatility to analyze this issue:

 average magnitude of trade-to-trade price changes;
 average volatility of duration-weighted bid-ask-midpoint; and
 percentage differences of high and low prices of the day.

    In all three measures, we did not detect any noticeable increase in 
volatility. In fact, the data indicates a decrease in volatility, 
consistent with what we found for the pilot issues. It should be noted 
that volatility, as measured during this time frame, could be 
influenced by a number of other market factors independent of 
decimalization.
Investor Costs
    We also reviewed the extent to which penny increments have caused 
orders to be broken into smaller trades. We looked for trends in trade 
size by looking at the average number of shares per trade report. 
Contrary to what some academics had predicted, according to early 
indications the average trade size for the decimalized stocks decreased 
only by 4.6 percent. Obviously, this is a calculation that would be 
benefited by covering a longer time period.
    The price dimension of quotes tells only part of the story. The 
quoted size is also significant. The Nasdaq quote montage is not a 
consolidated limit order book. Market makers frequently fill orders for 
far more size than indicated by their quotes, and they often fill 
orders at prices better than their own quotes. Nevertheless, analysis 
of the impact of decimals on displayed depth is of interest as it may 
be indicative of the total level of liquidity provided by the market. A 
more definitive analysis of liquidity postdecimals awaits future 
research.
    Quoted depth at the inside quotes declined for the newly-
decimalized stocks. Again, recall that decimalization moved from 16 
price points per dollar to 100 price points. We looked at two measures 
of inside depth, the average aggregate quoted depth at the inside and 
the number of market makers and electronic communications networks 
(ECN's) displaying quotes.
    This week, another effort was made by Nasdaq to analyze 
decimalization to understand its impact, if any, on institutional 
trading cost. While we believe this analysis is preliminary, we found 
good news for institutional trades on Nasdaq. It does not appear that 
decimalization on Nasdaq has caused higher institutional trading costs. 
A reasonable proxy to evaluate the cost of trades is to look at 
effective spreads. We know decimalization had a huge impact on retail 
trades, as effective spreads dropped by about 50 percent. We found that 
trading costs (effective spreads) fell for institutional trades as 
well. Effective spreads are based on actual trade prices, which are 
sometimes better and sometimes worse than the posted bid-ask quotes. 
The effective spread is defined as the twice the difference between the 
trade price and the average of the bid and ask (i.e, the quote 
midpoint).
    We looked at large trades, and institutional trades specifically, 
to see if decimalization thinned-out the market and caused those 
effective spreads for large/institutional trades to increase. We 
believe they did not. Our attempt to use our data showed 
``institutional'' prints got better fills (lower effective spreads) 
after decimalization (although by insignificant amounts for 5,000-
shareprints and higher) but the fills were slower. Again, this is based 
on the early days of decimal trading--as trading/sales practices adapt, 
this could change.
    One issue that has caused significant controversy with the shift to 
decimals is ``pennying'' or trading in front of a standing order by a 
penny. On this issue it is useful to recognize the advantages allowed 
by the Nasdaq market model of an all electronic market with competing 
dealers and ECN's. Nasdaq's quotes may be electronically accessed with 
no participant being provided a second look, we have not heard 
significant institutional concerns expressed about ``pennying'' on 
Nasdaq. We believe competing market makers and ECN's provide a hybrid 
market environment that discourages such unfortunate behavior. In fact, 
it is important to note that Nasdaq has been trading in increments 
finer than pennies since before April 9, 2001. Decimalization for 
Nasdaq pertained to quotes. We do recognize, however, that some 
institutional investors retain significant concerns over the impact of 
decimalization on market liquidity and we will continue to aggressively 
monitor our market to identify any basis for such concerns.
Conclusion
    Overall, the implementation of decimal trading for all Nasdaq 
stocks was carried out smoothly, as anticipated, with respect to 
capacity and market quality. Decimalization is a success story for 
Nasdaq, the industry and the American economy. We could not have 
accomplished it without the full cooperation of our member firms and 
their technology providers and the SEC.
    Most of the results are consistent with what we had anticipated. 
Indeed, overall spreads declined by a larger-than-expected percentage. 
Investors are seemingly enjoying some improvement of prices because of 
the tightened spreads.
    That said, we want to caution that decimal trading is still in a 
preliminary stage. As more time passes, we could see the results change 
over time. We plan to conduct our final detailed analysis for all three 
phases of decimalization for the SEC soon.
    Thank you for the opportunity to share Nasdaq's experiences with 
decimalization. I would be happy to respond to your questions.

                               ----------

               PREPARED STATEMENT OF CATHERINE R. KINNEY

        Group Executive Vice President, New York Stock Exchange
                              May 24, 2001

    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 1 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 1 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 2,000 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 \1/16\ 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 2 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 
percent. 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 percent to 50.7 percent.
    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 (for example, 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 \1/16\ variable. We also found 
that a majority of these occurrences were initiated by a floor broker 
or an order received through the Super Dot 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 percent decrease in the 
number of shares available at the published NYSE quote. While true 
liquidity (for example, 
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 pemit 
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 predefined, 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 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 
would be a step backward 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.

                               ----------

               PREPARED STATEMENT OF KENNETH D. PASTERNAK

    Chairman and Chief Executive Officer, Knight Trading Group, Inc.
                              May 24, 2001

    Chairman Enzi, Senator Dodd and Members of the Senate Banking 
Securities and Investment Subcommittee, thank you for this opportunity 
to testify today about the impact of trading in decimals. My name is 
Kenny Pasternak. I am Chairman, Chief Executive Officer, President, and 
Co-Founder of Knight Trading Group, the world's largest wholesale 
market maker for shares of both Nasdaq and non-Nasdaq equities. We are 
also a growing options market maker and an asset manager.
    At Knight, we like to think of ourselves as providing the 
processing power behind the explosive growth in securities trading via 
the Internet. We founded Knight with the purpose of empowering self-
directed individual investors--to give them the same speed, low cost 
and dependability in their securities transactions long enjoyed by 
large institutional investors. We are committed to offering the same 
efficient, dependable service, whether people wish to trade a single 
share of stock or a thousand shares--so our interest in the issues 
under discussion here today is acute.
    The Subcommittee has asked me to assess how decimal pricing is 
affecting the trading environment; whether the anticipated benefits of 
decimalization are being realized; and whether the transition to 
decimalized trading has brought about a need for change in securities 
regulations.
Decimal Pricing Has Led To Reduced Spreads But Not
Always Lower Trading Costs
    To answer the first of these questions, U.S. stock markets recently 
adopted decimalized trading in the belief that it would narrow spreads 
and lead to less costly order execution.
    There is no doubt that spreads have fallen. According to 
preliminary data, quoted spreads for Nasdaq stocks have fallen by an 
average 51 percent since the advent of decimalized trading. The decline 
has been greatest for the most active, lower-priced securities, which 
saw a 71 percent decline in quoted spread. Effective spreads \1\--a 
better measure of investor cost--fell by an average of 46 percent.
---------------------------------------------------------------------------
    \1\ Nasdaq Economic Research defines the effective spread as twice 
the absolute difference between the actual trade price and the 
prevailing bid-asked mid-point.
---------------------------------------------------------------------------
    It is important to note that the introduction of decimalized 
pricing is not in itself responsible for the narrowing of spreads. 
Rather, spreads have narrowed as a result of the decision by major 
market centers to reduce their Minimum Price Variation, or MPV. In 
1997, when the major market centers dropped the MPV from one-eighth of 
a dollar (12.5 cents) to one-sixteenth of a dollar (6.25 cents), the 
narrowing of spreads reduced trading costs for many investors, but 
increased costs for others. With the MPV now at a penny, the number of 
investors for whom costs have increased has been magnified. In other 
words, a higher percentage of orders are being processed less 
efficiently.
    Today's one-penny MPV has reduced price discovery, diminished 
liquidity and increased the level of trading activity required to 
execute an entire order. No market participant has an incentive to 
quote in size, as others can easily coopt that information and trade 
ahead by as little as one penny. While such problems were once 
experienced only by institutional investors, they now affect increasing 
numbers of 
individual investors as well.
    Knight Trading Group supports decimalization. We believe that by 
making stock prices easier to understand, decimalization encourages 
market participation and, therefore, benefits everyone. My purpose 
today is to focus this Subcommittee's attention on the adverse effects 
of the dramatic reduction in MPV adopted by the major market centers at 
the time when they implemented decimal pricing.
    The one-penny MPV is, in many circumstances, too small. In my view, 
the most important issue for this Subcommittee's consideration is how 
to encourage the markets to arrive at the correct MPV for a given set 
of circumstances. The thrust of my testimony today will be to explain 
why this issue is vital to the depth, liquidity and overall strength of 
our markets.
How the One-Penny MPV Hurts Investors
    The major market centers' recent adoption of the one-penny MPV has 
had enormous unintended consequences. Preliminary data suggests that, 
even for retail-sized orders, trading outside the spread has increased 
dramatically. The price discovery process has been impeded because 
displayed depth on Nasdaq has also declined--to approximately one-third 
of what it was before the transition to trading in decimals. Meanwhile, 
we see that more and more investors feel compelled to break down their 
buy and sell orders into smaller lots in order to achieve more control 
over their executions. Trades generally have increased in number but 
declined substantially in size.
    In addition, the one-penny MPV has occasioned a significant decline 
in the average number of market participants at the inside quote. In 
other words, those who provide enhanced liquidity to the markets are 
now committing less capital for the execution of individual investor 
trades than they did before the one-penny MPV.
    Those who proactively provide enhanced liquidity constitute a large 
and highly competitive industry that is absolutely essential to the 
efficient operation of the markets. They often provide liquidity 
automatically in amounts larger than the National Best Bid and Offer 
(NBBO). This automatic execution feature expands as the MPV increases 
and shrinks as the MPV decreases.
    At present, because of the one-penny MPV, many retail investors are 
paying more as the nature of executions changes from fast and complete 
to slow and fragmented. For example, during the month of January, 
Knight Securities alone provided liquidity above the NBBO size level in 
excess of 179 million shares. Without our enhanced liquidity, we 
estimate conservatively that investors would have paid nearly $4 
million more in execution costs.
    With the advent of the one-penny MPV, however, we and our 
competitors are providing enhanced liquidity in many fewer instances. 
Whereas, we previously provided instantaneous automatic execution at 
the NBBO price for any order of up to 2,000 shares, we now reserve 
automatic execution for much smaller orders. And in many instances, we 
do not offer automatic execution no matter how small the order.
    This decline in the availability of enhanced liquidity for Nasdaq 
stocks, coupled with the lower average quoted size, translates into 
slower and more fragmented executions--and ultimately higher costs for 
investors.
    In the listed markets, what we are seeing is a pronounced increase 
in the number of ITS ``trade-throughs.'' As you know, ITS--the 
Intermarket Trading System--is the linkage between the major exchanges 
and other trading centers. When an ITS participant like a New York 
Stock Exchange specialist sees another trading center offering a better 
price for more than a hundred shares, the specialist is obliged to 
either match that price or else forward the order on the investor's 
behalf. When the specialist fails to make good on that obligation, the 
omission is known as a ``trade-through.'' It means that the investor 
may actually receive a price dis-improvement.
    Our subsidiary, Knight Capital Markets (or KCM), which trades New 
York and American Stock Exchange listed equities on the Nasdaq 
InterMarketTM, has seen a marked increase in the number and 
frequency of Exchange member trade-throughs. During the first six 
trading days in February 2001, when decimal trading was introduced in 
all listed stocks, KCM experienced an average of more than 2,500 trade-
throughs per day by NYSE members--a more than four-fold increase over 
the predecimalized period.
Anachronistic Rules and Regulations Need To Be Reviewed
    Before investors can realize the full benefits of decimalization, 
including cheaper order execution, Congress, the SEC and the major 
market centers must address the negative consequences of narrowing 
spreads. Some of the blame can be traced to outdated rules and 
regulations that were written for an era of fractional pricing and 
substantially larger MPV's.
    One area that needs review is the long-held notion that our NBBO's 
standard provides the most accurate barometer as to whether an investor 
has received best execution. The concept of best execution remains a 
cornerstone of our markets, implying that broker-dealers have a duty to 
seek the most advantageous terms for their customers' transactions.
    For many years, the NBBO has been regarded as the ultimate measure 
of best execution. The NBBO, the consolidated stream of transaction 
reports and quotations mandated by Congress in 1975, has been available 
to the public on a real-time basis. Retail investors have come to 
expect automatic execution for orders up to a thousand shares at the 
NBBO's price or better.
    Automatic executions and guaranteed liquidity are decreasing as 
liquidity providers become less proactive. It is time to acknowledge 
that the NBBO has become less indicative of market liquidity. With the 
advent of the one-penny MPV, the NBBO has lost its value for all but 
the smallest orders. It gives no indication as to the price at which 
many orders can be executed in their entirety and at what speed.
    Indeed, the NBBO's prices can actually mislead the public with 
respect to the quality of order executions available among various 
market centers trading the same issues. The quality of executions 
afforded investor market orders by various market centers can vary 
widely in relation to the consolidated NBBO at the time of order 
receipt. The price at which an order was executed may not reflect the 
greater liquidity that might have been available at a competing market 
center. In short, the NBBO should no longer be regarded as sacrosanct.
Best Execution Entails More Than Getting the Best Price
    In many instances, price should not be the primary consideration in 
determining best execution. In the past, a broker-dealer could argue 
persuasively that it had discharged its best execution obligation 
merely by providing price improvement. Today, however, in an 
environment of narrowed spreads and diminished liquidity, providing 
price improvement may be less important than executing an order 
promptly and in its entirety. Broker-dealers should be obligated to 
consider such criteria as order size in seeking the destination that 
will provide the best execution.

Other Impediments to Fairer, More Efficient Markets

    While the Subcommittee and the SEC are reviewing the rules 
governing the 
National Market System, we would encourage them to consider a number of 
other impediments to fairer, more efficient markets. These include:

 The issue of connectivity, as manifested through market-center 
    linkages.
 The proper means of encouraging market participants to quote 
    and perform price discovery in larger sizes.
 The Short Sale Rule and other outmoded regulations that 
    actually impede the efficient handling of orders. Short-selling by 
    market professionals increases market liquidity, helping to offset 
    temporary imbalances in supply and demand. It also reduces the risk 
    that the price paid by investors will be inflated by temporary 
    supply impediments.
 And finally, the need for a new Trade-Through Disclosure Rule 
    for equities, similar to the rule recently adopted by the SEC for 
    options trading. Such a rule would require broker-dealer disclosure 
    whenever a customer's order is executed at a price that is inferior 
    to a published quote on another exchange. The rule would not 
    supplant the broker-dealer's duty to provide best execution, but it 
    would provide investors with the means to monitor broker-dealer 
    performance, while encouraging broker-dealers to develop effective 
    means of accessing better quotes published by other markets.

Conclusion

    Let me conclude by citing the words of recently retired SEC 
Chairman Levitt:

          It is not the pace of technology or the brilliance of 
        innovation . . . that guarantees the success of our markets, 
        but rather an unyielding commitment to quality. Quality in the 
        marketplace is faster, cheaper execution of transactions . . . 
        [and] efficient price discovery. Quality is the best execution 
        of customer orders. Quality . . . is the protection of the 
        investor interest. This last principal . . . reaffirms a simple 
        and salient truth--markets exist by the grace of investors.\2\
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    \2\ Arthur Levitt, Dynamic Markets, Timeless Principles, Remarks at 
Columbia Law School, New York, NY (September 23, 1999) (transcript 
available at http://www.sec.gov/news/speeches/spch295.htm) (emphasis 
added).

    That same ``simple and salient truth'' is at the heart of the 
issues we are discussing today: Whether our domain is Wall Street or 
Main Street, we are obliged to do what best serves the interests of all 
investors--large and small.
    The implementation of trading in decimals has made the markets more 
accessible to investors, but it has also led to a number of profound 
changes that diminish market liquidity, as well as the speed and 
efficiency with which investor orders are being executed.
    Only by recognizing and adapting to the changes occurring in the 
U.S. markets can we continue to protect the investor, strengthen market 
integrity, and maintain the position of leadership that our markets 
enjoy globally. Therefore, we hope that Congress and the Commission 
will review the Securities Exchange Act of 1934--especially its rules 
regarding the National Market System--then take the necessary steps to 
create markets that are fairer and more efficient for the largest 
possible number of trading participants.
    As this Subcommittee ponders the significant public-policy issues 
surrounding decimal pricing, my colleagues and I at Knight would 
welcome any opportunity to contribute further to the discussion.
    Thank you.

                PREPARED STATEMENT OF DONALD D. KITTELL

       Executive Vice President, Securities Industry Association
                              May 24, 2001

    I am Donald D. Kittell, Executive Vice President of the Securities 
Industry Association.\1\ 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 3 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.
---------------------------------------------------------------------------
    \1\ The Securities Industry Association brings together the shared 
interests of nearly 700 securities firms to accomplish common goals. 
SIA member-firms (including investment banks, broker-dealers, and 
mutual fund companies) are active in all U.S. and foreign markets and 
in all phases of corporate and public finance. The U.S. securities 
industry manages the accounts of approximately 50 million investors 
directly and tens of millions of investors indirectly through 
corporate, thrift, and pension plans. In the year 2000, the industry 
generated $314 billion of revenue directly in the U.S. economy and an 
additional $110 billion overseas. Securities firms employ approximately 
770,000 individuals in the U.S. (More information about SIA is 
available on its home page: http://www.sia.com.)
---------------------------------------------------------------------------
    I have organized my comments on the impact of decimalization into 
four subjects:

          I.   Systems and Operations
          II. Trading Rules and Regulations
          III. Market Making
          IV. Investor Benefits

    I would summarize SIA's conclusions on the impact of decimalization 
as follows:
    (1) The systems and operational aspects of the conversion went 
extremely well, primarily as a result of a carefully constructed phase-
in process of pilot trading, testing and evaluation by each market 
participant. Industry participants worked well together to accomplish 
the conversion--literally without incident. Thus far, actual message 
traffic has not reached the levels that early studies anticipated; 
however, it is still early to conclude that message traffic projections 
were overstated.
    (2) Trading rules and regulations are currently under study by 
market participants, self-regulatory organizations and the SEC. These 
rules address minimum price variation, short sales, limit order 
disclosure and protection, trade throughs, best execution, locked and 
crossed markets and block trading. It seems clear that timely 
adjustments to some of these rules are required.
    (3) The economics of trading and market making are under intense 
review by market participants and may be expected to result in changes 
in strategies and practices by securities firms and institutional 
trading desks. We expect this process to evolve over many months.
    (4) It is clear that the benefit 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 also clear 
that the harmonization of decimals across products and across 
international markets is a benefit. SIA believes that removal of the 
cloud of suspicion surrounding fractions was a constructive step. 
Conclusions about market liquidity, trading volume, volatility 
transaction costs, global competitiveness and the relative economic 
impacts upon market participants would, in our judgment, be premature.
    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.
I. Impact of Decimalization on Industry Systems and Operations
    (1) The securities industry's conversion of the equity and options 
markets to decimals took place, for listed securities, on January 29, 
2001 and for Nasdaq securities on April 9, 2001. The conversion 
proceeded smoothly and essentially without incident. All industry 
participants--exchanges, Nasdaq, specialists, market makers, data 
vendors, service bureaus, clearance and settlement organizations and 
securities firms reported a seamless transition.
    (2) The conversion to decimals followed 34 months of planning, 
coordination and testing. The cost of the conversion is estimated at in 
excess of $1 billion, by the Tower Group on behalf of SIA. These costs 
include programming changes, capacity increases and internal, as well 
as industry testing.
    (3) Message traffic (quotes, trades and administrative messages) 
has not risen to the levels projected by SRI Consulting in April 1999; 
however, it should be noted that SRI's projections were made during a 
period of very high market activity and were ``as of '' December 31, 
2001. We do not yet have experience in a market environment comparable 
to early 1999.
    (4) The SRI message traffic projections for options trading 
presented the most serious challenge to capacity. The options markets 
have introduced multiple listing, the quoting of size and the launching 
of a new Exchange at the same time as the conversion to decimals. As a 
result, the options exchanges have decided to trade in minimum price 
variations of 5 cents and 10 cents, instead of in pennies.
    (5) Market makers, specialists and trading desks report an increase 
in administrative workload as a result of the increase in trading 
increments. This workload deals with increases in cancels, cancel-and-
replaces, rejects and breaks, as well as the increased number of 
partial executions and executions per order. SIA has not attempted to 
quantify the increase in workload. It would be reasonable to assume 
that as market participants adapt to the decimal environment, 
productivity should improve.
    (6) Some SIA firms have raised concerns about the lack of a 
standardized decimal format in the Nasdaq market. The NYSE listed 
market provides that quotes and trades take place in pennies, with 
average prices of block trades carried out to four decimal places. The 
Nasdaq market provides that quotes be in pennies, but has no similar 
standard for trades. As a result, some Nasdaq market makers and ECN's 
execute trades carried out to mills, with the number of decimal places 
to the right of the decimal varying by participant. This lack of 
standardization is confusing and may result in operational 
inefficiency.
II. Impact of Decimalization on Trading Rules and Regulations
    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.
    (1) Minimum Price Variation: 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 5 cents 
for options priced under $3 and of 10 cents for options priced over $3.
    Each Exchange is anticipated to make recommendations as to minimum 
price variations in its June study.
    (2) Rules that are ``triggered'' by price ticks: 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.
    (3) Best Execution Rules: 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.
    (4) Block Trading Rules: 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.
III. Impact of Decimalization on Market Making
    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.
IV. Impact of Decimalization on Investors
    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.





                  PREPARED STATEMENT OF PETER JENKINS

          Managing Director and Head of Global Equity Trading
                       Zurich Scudder Investments
                              May 24, 2001

    Good morning, Chairman Enzi, Senator Dodd and Members of the 
Subcommittee on Securities and Investment, I thank you for the 
opportunity to comment on the implementation and future of the 
decimalized market. My name is Peter Jenkins and I serve as Managing 
Director and Head of Global Equity Trading at Zurich Scudder 
Investments.\1\ Zurich Scudder Investments manages nearly $400 billion 
in individual accounts, institutional portfolios and mutual funds, as 
well as private equity, private debt and hedge fund assets. Our clients 
include individuals, institutions, corporations, retirement funds, 
pension plans and insurance companies. It is important to note that 
while Zurich Scudder Investments, as well as other mutual funds, are 
correctly viewed as institutional investors because we frequently 
execute large sized-orders, we are acting on behalf of the millions of 
individual investors who put their trust in us to invest their money.
---------------------------------------------------------------------------
    \1\ Zurich Scudder Investments is the global investment management 
business of Zurich Financial Services Group (ZFSG). ZFSG is a global 
leader in the financial services industry, providing its customers with 
solutions in the area of financial protection and asset accumulation. 
The Group concentrates its activities in five business segments: 
nonlife and life insurance, reinsurance, Farmers Management Services 
and asset management. Headquartered in Zurich, Switzerland, the Group's 
worldwide presence builds on strong positions in its three key markets: 
the United States, the United Kingdom and Switzerland. It has offices 
in more than 60 countries reaching 35 million customers and employing 
73,000 people (30,000 of which are in the United States). Based on 
consolidated figures for 2000, the Group achieved gross premiums of USD 
50 billion. This amount includes insurance deposits, as well as 
premiums from the Farmers P&C Group. The net income amounted to USD 
$2.33 billion.
---------------------------------------------------------------------------
    As a trader for the last 21 years, I speak today on behalf of 
Zurich Scudder Investments, though the views that I express are shared 
by the Investment Company Institute, as well as many of my colleagues 
on the buyside. My comments today will illustrate some of the practical 
frustrations we as institutional traders face daily. I submit that the 
suggestions I offer will enhance overall market efficiency, which, in 
turn, will benefits all market participants and U.S. consumers.
    As a preliminary comment, I would like to point out that I strongly 
support the move to decimal pricing in the U.S. securities markets and 
the trading of securities in minimum increments of one penny. The move 
to smaller trading increments reduces the spread in securities, which 
in turn will result in benefits to our shareholders. In addition, the 
implementation of decimalization has enabled the pricing of securities 
in the United States to conform with securities markets around the 
world. Most institutional traders, such as myself, are continually 
adjusting to the new trading environment and we are already seeing the 
development of competitive products to help us cope with the change.
    Critics have contended that the problems that market participants 
are facing since the move to decimalization have arisen solely as a 
result of that move. I do not believe this to be the case. Instead, I 
would suggest that many of those problems are the result of the 
underlying structure of the securities markets on which we trade. 
Decimalization has simply brought these long-standing issues to the 
forefront, thereby highlighting the urgency of addressing several 
unresolved market structure issues. These include the need for the 
display of a meaningful depth of limit orders by both specialists and 
market makers; the need for priority rules for orders entered into the 
securities markets; and the need to address problems arising from the 
internalization of orders. I have long advocated that with the move to 
decimals, we need greater transparency and increased electronic access 
to the floor. Since decimalization, there are many more transactions, 
yet overall trading volume has not been affected. Furthermore, the 
depth or amount of shares on the inside market has been reduced.
    I should note that most of the difficulties that I have faced since 
decimalization have occurred while trading on the New York Stock 
Exchange (NYSE). In contrast, we have had few such problems when 
trading securities on the Nasdaq Stock Market, due largely to the fact 
that electronic communications networks (ECN's) have offered efficient 
access and have allowed traders to deal in smaller increments while at 
the same time retain control over order flow. The NYSE has taken some 
bold steps to address these emerging market issues, including the 
implementation of the ``Network NYSE,'' a program that offers a limited 
degree of transparency and connectivity for both institutional and 
retail customers. Furthermore, I commend the Exchange for attempting to 
address some of the unintended consequences of decimalization by 
introducing two initiatives--Depth Condition and Depth Indicator--to 
increase transparency and improve the communication of market depth in 
a decimal trading environment, and by allowing users to view the entire 
NYSE electronic limit order book.
    Since the implementation of decimalization on the NYSE, the 
execution of large orders has actually been hampered by the reduced 
transparency of orders on the Exchange's limit order book and by 
increased instances of market participants stepping ahead of orders by 
increments of as little as one penny. The net effect has been for the 
institutional trader to lose control of his/her order flow, since no 
effective tools exist in the NYSE listed market to reach the market 
efficiently. The ``upstairs'' trader does not have the time to 
negotiate trades as quotes change rapidly. This lack of control has led 
the ``upstairs'' trader to expose less to the Market for fear of being 
``front run'' for a penny (See Attachment A). Examples such as this 
have created a disincentive for market participants to enter orders of 
any significant size into the Exchange. As a result, an increasing 
amount of order flow has left the Exchange and been directed to 
alternative markets where institutions face less of a risk of having 
their orders stepped ahead, further fragmenting the listed market.
    These problems are not due to decimalization. They result from the 
fact that the NYSE does not provide sufficient protection to the orders 
that I--and other institutional traders--utilize in trading large 
amounts of stock. Today, when an electronic order is sent to the 
exchange via Super Dot (an electronic order routing system that links 
member firms to specialists' posts on the trading floor,) the order is 
first exposed to the brokers on the floor who surround the specialists 
post prior to actually interacting with the Limit Order book. This 
technique is called ``an attempt at price improvement.'' If an 
electronic order is small, it may in fact receive price improvement. 
If, on the other hand, the electronic order is large, the specialist 
may first allow the crowd to interact with the limit order prior to 
execution of the trade.
    These hidden orders in the ``pockets'' of the floor brokers gain 
standing. When an institution attempts to interact with limit orders on 
the book, most institutional traders feel this exposure to the crowd is 
unnecessary. If the ``upstairs'' trader were able to interact with the 
limit order book without delay, floor brokers might be compelled to 
make instantaneous decisions and not use limit orders as options. In 
order to resolve these problems, institutions must have facilities for 
the automatic execution of large orders on the Exchange and the ability 
to trade large orders without subjecting those orders to the price 
improvement mechanisms.
    These remedies to the problems that institutions are facing were 
recently included in a letter from the Investment Company Institute 
(ICI) to the NYSE, which I have attached as part of my official 
statement (See Attachment B). In this letter, the ICI recommends 
changes to the NYSE's new system to facilitate the ability of 
institutional investors to trade large orders on the Exchange 
(``Institutional Xpress''). Specifically, the ICI recommends that large 
orders eligible for execution in that system should not be permitted to 
be represented by specialists to the crowd on the floor of the 
Exchange. In addition, the orders do not become expressible until it is 
on the best bid or offer for a time period of 30 seconds. This should 
be changed, to enhance efficiency, there should be no time limit. 
Institutional Xpress also requires that an order be at least 25,000 
shares in size--this number is too high. Furthermore, Institutional 
Xpress should be able to reach through the offer to get to the 
available liquidity pool. These are all significant concerns that must 
be addressed.
    While the NYSE and the specialists will tell you that they are 
benefiting investors by providing price improvement, I, along with my 
colleagues on the buyside (would gladly forego this price improvement, 
which can be as little as a penny in a decimal environment, to receive 
protection for our displayed orders. By making this change to the 
Institutional Xpress system, the NYSE has the opportunity to promote 
the placement of limit orders on the book by providing protection for, 
and rewarding the placement of, those orders and attracting order flow. 
These improvements that I suggest will serve to increase the depth and 
liquidity of the market. The changes I suggest--both a stronger limit 
order book and greater transparency--will result in enhanced liquidity 
for all users of the NYSE. Greater liquidity enables more cost-
effective execution. It follows that the more transparent the market 
is, the more 
informed decisions an investor can make whether he/she is an 
institutional trader or a retail customer.
    In closing, I have directly worked with the NYSE and other 
exchanges for years to voice my opinions--as well as competitors'--on 
how best to provide institutions the liquidity to perform effectively 
on behalf of our clients' portfolios. These changes pose no threat to 
the NYSE, rather, these enhancements offer the ability for institutions 
and retail participants to transact efficiently and at the best price.
    I thank you again for this opportunity to testify, and I am pleased 
to answer any questions. 



 

 

 

 

                PREPARED STATEMENT OF ROBERT B. FAGENSON

           Vice Chairman, Van der Moolen Specialists USA, LLC
        Vice Chairman of The Specialist Association of the NYSE
                              May 24, 2001

    I am Robert B. Fagenson, Vice Chairman of Van der Moolen 
Specialists USA, LLC, a New York Stock Exchange (``NYSE'') specialist 
firm. I appear before you today in my capacity as a specialist.
    On behalf of the Association, I want to express my thanks for this 
opportunity to testify before the Subcommittee on the effects that 
``decimalization''--that is, changing the typical trading increment for 
securities from sixteenths to pennies--has had on our securities 
markets.
    In April 1997, I had the pleasure of testifying before the House 
Subcommittee on Finance and Hazardous Materials concerning H.R. 1053, 
``The Common Cents Stock Pricing Act of 1997.'' That bill, which was 
never passed, would have required the Securities and Exchange 
Commission (``SEC'') to adopt a rule that would replace trading in 
fractions with trading in decimals. The bill also would have left it to 
the SEC to decide the minimum number of cents per share that should 
characterize bid and offer quotations for stocks and last sale reports 
for those securities in our markets. The primary purpose of The Common 
Cents Act and the move to decimal trading was to reduce the ``spread'' 
between bid and offer prices for securities. The spread was widely 
regarded as excessive and as a cost visited on public investors that 
was not subject to the moderating force of competition. Creating more 
pricing points in each dollar of stock traded (potentially one hundred 
compared to the sixteen that characterized traditional trading 
fractions in our markets), according to theory, would enhance price 
competition among traders and thereby reduce spreads and lower the 
costs that they represented. In short, fixed minimum fractional spreads 
were said to punish investors and reward traders. A beneficial side 
effect of eliminating fractional trading increments was supposed to be 
elimination of ``payment for order flow,'' a practice whereby a market 
maker or market pays money--a cent or more per share--to a broker to, 
in effect, ``buy'' that broker's flow of customer orders.\1\
---------------------------------------------------------------------------
    \1\ The SEC considered banning payment for order flow in 1993. 
Ultimately, however, and wrongly, in our view, the SEC decided to 
permit it to continue so long as the practice was disclosed to 
brokerage customers whose orders were being sold. See SEC Release Nos. 
34-33026 (October 6, 1993) and -34902 (October 27, 1994).
---------------------------------------------------------------------------
    Imagining then that the worst that could happen as a result of a 
change to decimal trading would be a reduction in the trading increment 
to as little as a penny, we predicted in 1997 the following:

    1. We believed that decimalization and any consequent narrowing of 
spreads between bid and offer prices would reduce the profitability of 
payment for order flow and internalization of retail orders in listed 
stocks. We think that this has occurred, but not to such a degree as to 
eliminate either payment for order flow or internalization--both of 
which we regard as bad practices.
    2. We thought that decimalization would tend to reduce the ability 
of regional stock exchange specialists that trade NYSE stocks to do so. 
We also think that this is happening.
    3. We said that decimalization, especially if the trading increment 
was reduced to a penny, would incent on- and off-floor market 
professionals to trade for their own accounts ahead of customers by 
stepping in front of their orders by a single penny. This, too, has 
happened. ``Stepping ahead'' has acquired a bad name in today's markets 
even though it improves the price for the other side of the trade--
something that those who characterize the practice seem to forget, 
focusing only on the disappointed would-be buyer or seller and not at 
all on the ``improved'' other side of the trade. We observe that 
``stepping ahead'' of (or ``pennying'') customers almost always seems 
to involve trading by market professionals, including institutional 
traders, rather than specialists and market makers, at least in the 
exchange markets. Market professionals acknowledge that they engage in 
this practice, even though they dislike it, because they believe that 
their responsibilities force them to do so in a penny-increment trading 
environment.
    4. We pointed out that decimalization would reduce transparency in 
our markets by cluttering bid-offer quotation displays with short-lived 
bids and offers for small amounts of shares that would flicker in and 
out of existence too rapidly to permit public customers to take 
advantage of apparent price improvements. Further, we said that the 
overall effect would be to make the actual prices of stocks more 
difficult to determine by increasing the number of trades displayed on 
the consolidated tape at very small price changes. This prediction also 
has come true--and to an even greater extent than we anticipated in 
1997.
    5. Finally, we predicted that, if spreads were significantly 
reduced, the sizes displayed to the markets in connection with 
prevailing bid and offer prices also would be reduced. This, too, has 
occurred, and to a much greater degree than we foresaw in 1997.

    Collectively, we think that the most severe and adverse of the 
effects that have been engendered by decimalization have been these:

    1. The significance of the pricing information available to public 
investors and market professionals--namely, last sale reports and 
displayed bid and offer quotations--has been blurred. This is because, 
with one hundred pricing points are available for each dollar of stock 
traded instead of the sixteen that existed when we traded in fractions, 
stock prices now change much more rapidly, and because the amount of 
stock available to be bought or sold at any single pricing point is 
much smaller than was the case when fewer pricing points were 
available.
    2. There has been a loss of predictable and visible liquidity at 
the prices of displayed bids and offers (in the form of quotes with 
size). This has happened because interest in buying or selling is 
spread out among more of the possible pricing points than was the case 
when there were fewer of them, and because, since only the highest bid 
and lowest offer in each market is widely disseminated, the degree of 
liquidity, or the lack of any liquidity, at prices away from the best 
bid and offer prices is hidden.
    3. There now is a trend toward trading in increments as small as 
\1/100\ of a cent or $.0001. So far, this phenomenon has been confined 
to trading in over-the-counter (``OTC'') stocks, where visible 
liquidity is now significantly lower than it was in a fractional 
trading environment. The adverse effects of such trading have been 
partially obscured by the fact that the NASD's mechanisms for 
disseminating consolidated last sale and bid and ask information in OTC 
stocks are not yet capable of showing prices in increments smaller than 
a penny. Display of actual four-decimal place prices (or even smaller 
increments), we believe, would sharply amplify these negative effects.

    In our view, the foregoing factors indicate that trading stocks in 
penny increments may have confused and disadvantaged public investors 
rather than helped them. Spreads may have been reduced, but investors 
cannot put those ``saved'' spread increments in their pockets. Instead 
they find that, in a penny-trading environment, even modestly sized buy 
and sell orders are sometimes broken into three or four separate parts 
before they can be filled--and that those parts are filled at different 
prices. In addition to getting different prices, this usually also 
involves increased clearing costs for the customer. This did not occur 
when we traded in fractions. Before the change to decimals, orders of 
modest size did not move market prices away from the levels that 
prevailed before those orders were entered in the market. These costs, 
unlike the supposed savings inherent in ``reduced spreads,'' are 
readily understood by all.
    How did we get to where we are from a well-meaning effort to make 
stock trading more understandable and less expensive for the public? 
Most investors, we would think, like everyone else, really would rather 
do away with pennies altogether, 
rather than be forced to carry and use them--though we all do. No one 
at all, however, carries mills or tenths of mills in their pockets or 
can be expected to think rapidly in terms of such units. Can it be said 
that a price of 10\1/4\ is harder to understand than a price of 
$10.2639? We think not.
    The Association believes that adjustments can be and are being made 
to overcome the problems that have attended the movement from sixteen 
pricing points for each dollar in fractional trading to one hundred 
such points in a penny trading environment. For example, investors are 
learning that the smaller sizes associated with each such pricing point 
displayed as part of a quotation can be and often are quickly 
exhausted, forcing prices to the next higher or lower level. As a 
result, investors are finding that it makes sense to place a limit or 
``cap'' on the prices they are willing to pay or accept when they buy 
or sell and to confer discretion on their brokers to work within the 
cap to fill their orders. This trading process, however, and the 
diminished liquidity available at any particular pricing point, may 
well result in average prices for investors above the lowest offer or 
below the highest bid displayed at the time their orders were entered 
in the market.
    Under these circumstances, are investors paying more to buy stock 
or getting less when they sell stock than was the case before the 
introduction of decimal trading? We have no data to support a 
conclusion in this regard. At the same time, because sizes associated 
with displayed bids and offers seem to us to be so much smaller than 
they were in a fractional trading environment, it is entirely possible 
that it has become more expensive, on the whole, for ordinary investors 
to transact than formerly was the case.
    Our final concern--reduction of the trading increment below one 
penny--is our most serious one. Reduction of the trading increment 
below a penny, in our view, could damage the integrity of the markets' 
pricing function and undermine public confidence in the fairness of our 
markets. This could occur because trading in tiny, sub-penny increments 
will even more completely obscure the true state of the market as it is 
seen by individual and institutional investors alike, as liquidity at 
particular price points is buried beneath very small size amounts 
associated with 
momentarily higher bids or lower offers. In turn, this effect can be 
expected to increase investor uncertainty as to the price at which a 
buy or sell order of any substantial size can be executed and to 
increase buyers' and sellers' anxiety that their intentions will become 
known to the market before their orders can be filled. Last, because of 
the spray of prices resulting from sales in increments smaller than a 
penny, confidence that any particular price is ``the'' price at the 
moment will be sapped.
    Our securities markets are acknowledged by all to be the most 
powerful engine for the raising of capital ever conceived. Risking the 
basic pricing and trading mechanisms of that engine and public 
confidence in them by allowing the uncontrolled splintering of the 
prices at which stocks trade and in which bids and offers are made is 
worse than foolish: it is dangerous.
    For the foregoing reasons, we urge the Subcommittee to consider 
legislation that would not only empower the SEC, but also require that 
agency, to determine appropriate trading increments for different 
categories of stocks (that is, actively or thinly traded, highly 
capitalized or less robust, and so on) and to adopt an appropriate rule 
that would compel the markets and broker-dealers to adhere to those 
increments in the trading of securities. In 1997, we thought that it 
would not be necessary to ask for government assistance to deal with 
the consequences of decimalization. Experience with decimals to date, 
however, has persuaded us that we were wrong and that such assistance 
is badly needed now. We are unsure whether the SEC has authority today 
under the Securities Exchange Act of 1934 to adopt particular trading 
increments. We are confident, however, that, with the help of the 
securities industry and academicians, the SEC will be able to develop a 
rational limit on what now is a dangerously uncontrolled process of 
endlessly splintering the trading increment.
    I would be pleased to respond to questions.

  RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM LAURA S. 
                             UNGER

Q.1. At the May 24, 2001, Subcommittee hearing I asked you 
about the status of the Commission's consideration of repealing 
or significantly revising the Short Sale ``Uptick'' rule. You 
stated that the Commission would be coming out with a proposal 
shortly. I note that the Commission's semiannual regulatory 
agenda, published May 14, 2001, in the Federal Register, states 
that the Commission expects to publish a notice of proposed 
rulemaking (NPRM) on the Short Sale Rule by the end of May 
2001, which is this month. Please clarify for the Subcommittee 
the Commission's time frame for issuing the NPRM.

A.1. We anticipate that the staff 's recommendations on 
possible revisions to Rule 10a-1 will be ready for the 
Commission to consider by late summer.

Q.2. In addition, it is my understanding that several 
commenters to the October 1999 SEC concept release on revision 
or repeal of the Short Sale Rule believe that the rule should 
be repealed in its entirety. Decimalization further reduces the 
economic justification for retention of the Short Sale Rule. Is 
the SEC considering a repeal of the Short Sale Rule, or merely 
a revision to the rule?

A.2. As you note, the Commission in 1999 published a concept 
release seeking comment on Rule 10a-1. The concept release 
sought comment on eight concepts related to the regulation of 
short sales of securities, including eliminating Rule 10a-1. 
The comments received in response to the concept release were 
mixed. A few commenters (9 out of a current total of 2,577) 
advocated repealing the rule altogether, while others favored 
retaining the rule with modifications. The majority of the 
comment letters were delivered electronically by individual 
investors calling for extending short sale regulation to cover 
nonexchange listed securities, such as Nasdaq Small Cap, OTC 
Bulletin Board, and Pink Sheet securities. The staff is 
currently developing a proposal on the Short Sale Rule for the 
Commission's consideration. It would be premature to comment in 
detail on what that proposal will be until the Commission has 
had a chance to consider the staff 's recommendation.
    The staff does intend, however, to recommend that any 
proposal address the issue of decimalization. While the staff 
believes that it may be premature to say that decimalization 
has further reduced the economic justification for retention of 
the Short Sale Rule, decimalization raises at least two other 
distinct questions regarding the operation of Rule 10a-1. The 
first is the extent to which the reduction in the minimum price 
increment from \1/16\ (6.25 cents) to a penny makes it more 
difficult to comply with the rule, due to rapid trade and quote 
price changes. The second question is, in a decimals 
environment where price differences between trades can be a 
penny (or less), how much above the last sale (or bid) should a 
short sale be executed in order to achieve the goals of the 
rule. The staff intends to recommend that the Commission 
inquire in the proposing release regarding the effects of 
decimal-ization on the Short Sale Rule and will recommend 
regulatory changes, as necessary.
    Any short sale proposing release will be designed to 
attract constructive input from a broad range of market 
participants, and will encourage commenters to supply data to 
support their views. We hope that these responses will assist 
our understanding of both the costs and benefits of the current 
Short Sale Rule. We will study the comments and any 
accompanying data to improve the regulation of short selling.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM CATHERINE R. 
                             KINNEY

Q.1. At the May 24, 2001, Subcommittee hearing there was some 
discussion regarding the SEC revising or repealing the short 
sale uptick rule. The SEC indicated at the hearing that they 
will be issuing a proposed rule on revising or repealing the 
Short Sale Rule in the very near future. The consensus seems to 
be that the Short Sale Rule should be scaled back, if not 
totally repealed. Do you believe that the rule has any 
continued economic or policy justifications? If so please 
identify the market capitalization and trading volume 
thresholds, as well as other criteria, which you believe are 
appropriate.

A.1. The New York Stock Exchange does not favor elimination of 
the Short Sale Rule. We continue to believe that this rule 
provides important safeguards in protecting the public interest 
and in maintaining an orderly marketplace. The rule continues 
to offer appropriate regulatory safeguards for allowing short-
selling in a rising market, while prohibiting short-selling 
from being used to accelerate a declining market. The 
elimination or modification of the rule could have the effect 
of encouraging short-selling activities in which the price of a 
security could be manipulated. We also understand that 
companies that have listed their securities on the Exchange 
favor the retention of the rule.
    If the SEC issues a proposed rule to revise or repeal the 
Short Sale Rule, the Exchange will comment on such a specific 
proposal at that time.

Q.2. In your testimony, you indicate that price improvement on 
the New York Stock Exchange has increased, particularly for 
smaller orders. Please explain how the NYSE measures price 
improvement.

A.2. When placing a market order, there is an expectation that 
the order will be filled at the current best bid or offer--for 
example, the quote. The NYSE measures price improvement by 
comparing the actual price with that quote. The statistics are 
further summarized in categories by order size.
    Published along with the quote is the number of shares 
available to buy or sell at that price. When calculating price 
improvement numbers, the NYSE does not include orders that 
exceed the published size. We do not calculate the statistics 
for stocks with a per share price above $1,000, or stocks 
trading in round lots of less than 100 shares, and we exclude 
odd lots from our calculations.
    In May 2001, 47 percent of all orders executed on the 
Exchange received price improvement. The Exchange publishes 
best execution statistics each month on our website, 
www.nyse.com.

Q.3. The Investment Company Institute, in a March 1, 2001, 
letter to Mr. Grasso, Chairman of the New York Stock Exchange, 
has requested changes to the functioning of Institutional 
Xpress to ``facilitate the ability of mutual funds and other 
institutions to trade large orders on the Exchange.'' What are 
the drawbacks, if any, to implementing the changes requested in 
the letter, such as the 30-second requirement and the automatic 
execution of large orders? Would anyone be disadvantaged by 
these proposed changes?

A.3. We believe that some of the changes requested by the 
Investment Company Institute would increase volatility by 
diminishing the ability of all orders to participate in the 
auction market. It is important to have a mix of institutional 
and retail order flow in the price discovery process, and to 
ensure that both institutional and retail orders receive the 
best price through the same auction process. We need to gain 
experience with Institutional XPress, and we will be reviewing 
the suggestions submitted by the ICI and other market 
participants.
    We have, however, taken some action in accordance with 
discussion in the Exchange's initial rule filing for the 
approval of Institutional XPress. We stated at that time that 
certain changes were to be considered within 6 months after the 
initial implementation of the XPress product. On June 11, 2001, 
the Exchange filed with the SEC a proposed rule change relating 
to Institutional XPress quotations and orders. The rule filing 
proposes to reduce the minimum size of an XPress quote from 
25,000 shares to 15,000 shares; reduce the time period for 
designation as an XPress quote from 30 seconds to 15 seconds; 
and reduce the minimum size of an XPress order from 25,000 
shares to 15,000 shares. This current rule filing, which has 
not yet been acted upon by the SEC, is in accord with our 
previously expressed intention.

Q.4. During his testimony before the Subcommittee, Peter 
Jenkins of Zurich Scudder Investments expressed some concern 
about trading on the NYSE. He mentioned that the one cent MPV 
has hampered the ability of institutional investors to obtain 
executions on the NYSE floor, because market participants can 
step in front of any order, for as little as one cent price 
improvement.
    Mr. Jenkins testified that the problem institutional 
investors face is due to the lack of control they can exercise 
over the trades they send to the floor, for example, since 
trades are exposed to the floor crowd, large institutional 
orders do not receive ``sufficient protection'' and can be 
broken up. Please respond to these comments by Mr. Jenkins. In 
particular, please address whether the NYSE floor 
specialists are the market participants who are stepping in 
front of institutional investors' large block trades.

A.4. While there may be a perception that specialists are 
stepping ahead of customers at a minimally improved price 
(commonly referred to as ``pennying''), in fact a recent study 
shows that two-thirds of such ``one-tick-better'' trades are by 
nonspecialists. The vast majority (about 85 percent) of 
``pennying'' quotes appear to arise from system limit orders. 
The facts suggest that, contrary to reports in the press and 
elsewhere, in the large majority of trades NYSE's floor 
specialists are NOT stepping in front of institutional 
investors' large block trades.
    This study, ``Getting `Pennied': The Effect of 
Decimalization on Traders' Willingness to Lean On the Limit 
Order Book at the New York Stock Exchange,'' is attached and 
can also be found on our website, www.nyse.com.
    Nevertheless, the NYSE has taken steps to assuage the 
concerns of institutional investors. The NYSE has recently 
taken action to address the ability of institutional investors 
to execute large transactions at a single price. In early June, 
our Board approved an amendment to our Rule 72(b) to provide 
that a specialist may not effect a proprietary transaction to 
provide price improvement to either side of a ``clean cross'' 
transaction. The proposed amendment will preserve the auction 
market principle of price improvement since orders sent in from 
off the trading floor and placed with the specialist or a floor 
broker may offer price improvement at any minimum variation. 
This proposed rule change was filed with the SEC on July 2. The 
NYSE has taken these steps to reassure this important segment 
of the market of the integrity of our floor-based auction 
market.