[Senate Hearing 107-346]
[From the U.S. Government Printing Office]
S. Hrg. 107-346
THE IMPLEMENTATION AND FUTURE
OF DECIMALIZED MARKETS
SUBCOMMITTEE ON SECURITIES AND INVESTMENT
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
THE CURRENT STATUS OF IMPLEMENTATION OF DECIMAL PRICING FOR SECURITIES,
INCLUDING AN ESTIMATION OF COSTS AND BENEFITS
MAY 24, 2001
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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
C O N T E N T S
THURSDAY, MAY 24, 2001
Opening statement of Senator Enzi................................ 1
Opening statement of Senator Corzine............................. 2
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
THE IMPLEMENTATION AND FUTURE OF DECIMALIZED MARKETS
THURSDAY, MAY 24, 2001
Committee on Banking, Housing, and Urban Affairs,
Subcommittee on Securities and Investment,
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
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 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
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.
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.
I know that got him in trouble once.
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
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
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
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
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
indications'' and ``depth conditions'' to reflect market
interest in a security below the published bid and above the
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
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
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
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
Senator Enzi. Okay. You are not suggesting a change at the
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
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
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
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
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
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
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
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
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
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
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.
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
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.
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
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
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
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.
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
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
Senator Enzi. Thank you.
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
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
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
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
Thank your for your attention and I would be happy to
respond to questions.
Senator Enzi. Thank you, Mr. Kittell.
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.
Senator Enzi. Thank you.
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
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
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
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
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
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
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
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.
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
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
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
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
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. 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
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
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
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
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. 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
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?
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. 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
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
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
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
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
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?
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
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
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.
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
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.
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.
\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
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.
\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
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\
\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
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\
\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
\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
\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
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
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
\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
\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).
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
\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.
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.
PREPARED STATEMENT OF J. PATRICK CAMPBELL
President, Nasdaq U.S. Markets and
Chief Operating Officer, The Nasdaq Stock Market
May 24, 2001
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
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.
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
(2) Nasdaq's market has seen a dramatic decrease in spreads;
(3) There is no evidence on our market, to date, that
institutional investors are bearing the burden of any
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
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
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
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
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.
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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.
Let me conclude by citing the words of recently retired SEC
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\
\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
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.
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
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
(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
(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
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
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
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
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
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
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
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
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
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
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
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
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
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.
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.
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
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
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,
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
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
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