Securities Pricing: Trading Volumes and NASD System Limitations Led to
Decimal-Trading Delay (Letter Report, 09/20/2000, GAO/GGD/AIMD-00-319).

Pursuant to a congressional request, GAO examined the progress that the
securities industry has made toward the implementation of decimal
pricing for U.S. stocks, focusing on: (1) what were the specific reasons
that the Nasdaq market was not ready for the July 3, 2000,
implementation date and how the National Association of Securities
Dealers', Inc.(NASD) decimal-trading preparations compared with those of
the New York Stock Exchange (NYSE); (2) how the Securities and Exchange
Commission (SEC) approached oversight of the securities industry's
implementation of decimal trading and how this compared with its year
2000 oversight effort; and (3) what challenges remain regarding
implementing decimal trading for the industry.

GAO noted that: (1) although the Nasdaq market experienced a surge in
trading volume in late 1999, its existing systems were able to process
the resulting message traffic; (2) however, NASD was unable to meet the
original July 2000 implementation date for decimal trading in stocks
because the new system it developed for quoting prices in decimals had
insufficient capacity to process the increase in trading volume; (3) the
primary reason that this system's capacity was insufficient was that it
lacked the capability to use multiple computers for processing; (4) in
addition, NASD's volume forecasting methodology does not adequately
incorporate the volatility of the traditing on its market; (5) it lacks
effective criteria for determining whether its systems have sufficient
excess capacity; (6) in contrast, both NYSE's processing environment and
approach for preparing for decimal trading differed from that of NASD;
(7) NYSE reported being ready to trade in decimal prices by the original
July deadline; (8) NYSE experienced lower increases in its trading
volumes than did the Nasdaq market, and its officials indicate that they
use a more flexible information technology architecture that allows
their exchange to more easily expand processing capacity; (9) SEC's
approach for overseeing the securities industry's implementation of
decimal trading was similar to the approach it used to oversee the
industry's year 2000 readiness efforts; (10) although SEC conducted
various reviews of NASD that raised capacity concerns, SEC officials
relied on NASD's representations regarding its decimal-trading
preparations and did not identify in advance the system limitations that
caused NASD's delay; (11) various challenges remain for the industry as
it progresses toward implementing decimal trading for all securities yet
to be converted to decimals; and (12) additional challenges for
securities market participants may arise if all securities listed on
NYSE and the other regional exchanges begin trading in decimal prices
before such trading begins for Nasdaq-listed securities, but industry
participants indicated that various steps could be taken to address
these challenges.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD/AIMD-00-319
     TITLE:  Securities Pricing: Trading Volumes and NASD System
	     Limitations Led to Decimal-Trading Delay
      DATE:  09/20/2000
   SUBJECT:  Systems design
	     Stock exchanges
	     Securities regulation
	     Strategic information systems planning
	     Prices and pricing
	     Brokerage industry
	     Internal controls

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United States General Accounting Office
GAO

Report to Congressional Requesters

September 2000

GAO/GGD/AIMD-00-319

SECURITIES PRICING
Trading Volumes and NASD System Limitations Led

to Decimal-Trading Delay

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Contents
Page 361 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Letter                                                                      1
                                                                             
Appendix I                                                                 38
Comments From the
Securities and Exchange
Commission
                                                                             
Appendix II                                                                43
Comments From the Nasdaq
Stock Market, Inc.
                                                                             
Appendix III                                                               46
GAO Contacts and Staff
Acknowledgments
                                                                             
Related GAO Products                                                       48
                                                                             
Figures                    Figure 1:  Average Daily and Peak                7
                           Shares Traded on the Nasdaq Market,
                           by Month (1997-2000)
                           Figure 2:  Average Daily Quotation               8
                           Messages on the Nasdaq Market, by
                           Quarter (1993-2000)
                           Figure 3:  Average Shares Per Trade on           9
                           the Nasdaq Market (1993-2000)
                           Figure 4:  Planned Phases for                   24
                           Implementation of Decimal Trading
                                                                             

Abbreviations

ARP       Automation Review Policy
ECN       electronic communication network
IQMS      Integrated Quote Management System
MPS       messages per second
MPV       minimum price variation
NASD      National Association of Securities
Dealers
NYSE      New York Stock Exchange
OCIE      Office of Compliance Inspections and
Examinations
OPRA      Options Price Reporting Authority
SEC       Securities and Exchange Commission
SIA       Securities Industry Association
SRO       self-regulatory organization

B-285368

Page 34  GAO/GGD/AIMD-00-319 Decimal-Trading Delay
     B-285368

     September 20, 2000

The Honorable Thomas J. Bliley, Jr.
Chairman, Committee on Commerce
House of Representatives

The Honorable Michael G. Oxley
Chairman, Subcommittee on Finance and
   Hazardous Materials
Committee on Commerce
House of Representatives

The Honorable Edward J. Markey
Ranking Minority Member, Subcommittee on
   Telecommunications, Trade, and Consumer
Protection
Committee on Commerce
House of Representatives

     This report responds to your April 27, 2000,
request that we examine the progress that the
securities industry has made toward the
implementation of decimal pricing for U.S. stocks.
The U.S. equity markets are the only major equity
markets in the world that still use fractional
pricing and some observers have projected
significant savings to investors following the
implementation of decimal pricing.

     In January 2000, the Securities and Exchange
Commission (SEC) issued an order requiring all
stocks and options exchanges and the National
Association of Securities Dealers, Inc. (NASD),
which administers the Nasdaq Stock Market, Inc.,
to develop a plan that would ensure that decimal
trading would begin by July 3, 2000. However, in
March 2000, NASD officials announced that they
would not be able to meet this deadline. As a
result of this announcement, SEC suspended the
order requiring the markets to implement decimal
trading by July 3, 2000.  On August 28, 2000 after
SEC issued a new order, a small number of stocks
and options began trading in decimal prices, and a
new phased schedule for the implementation of
decimal trading was put into place.  This schedule
called for all securities to be quoted and traded
in decimals by April 9, 2001.

     As agreed with your office, this report
addresses the following questions: (1) what were
the specific reasons that the Nasdaq market was
not ready for the July 3, 2000, implementation
date and how NASD's decimal-trading preparations
compared with those of the New York Stock Exchange
(NYSE); (2) how SEC approached oversight of the
securities industry's implementation of decimal
trading and how this compared with its Year 2000
oversight effort; and (3) what challenges remain
regarding implementing decimal trading for the
industry.

Results in Brief
     Although the Nasdaq market experienced a
surge in trading volume in late 1999, its existing
systems were able to process the resulting message
traffic.  However, NASD was unable to meet the
original July 2000 implementation date for decimal
trading in stocks because the new system it
developed for quoting prices in decimals had
insufficient capacity to process the increase in
trading volume. The primary reason that this
system's capacity was insufficient was that it
lacked the capability to use multiple computers
for processing.  In addition, NASD's volume
forecasting methodology does not adequately
incorporate the volatility of the trading on its
market; thus, it lacks effective criteria for
determining whether its systems have sufficient
excess capacity.  In contrast, both  NYSE's
processing environment and approach for preparing
for decimal trading differed from that of NASD.
NYSE reported being ready to trade in decimal
prices by the original July deadline. NYSE
experienced lower increases in its trading volumes
than did the Nasdaq market, and its officials
indicate that they use a more flexible information
technology architecture that allows their exchange
to more easily expand processing capacity.

     SEC's approach for overseeing the securities
industry's implementation of decimal trading was
similar to the approach it used to oversee the
industry's Year 2000 readiness efforts. As it did
for the industry's Year 2000 preparations, SEC
assisted in the establishment of standards and set
progress deadlines for securities market
participants.  Also similar to its Year 2000
oversight, SEC relied largely on industry
participants to report their own progress and has
conducted some on-site examinations of market
participants' preparations for decimal trading.
Although SEC conducted various reviews of NASD
that raised capacity concerns, SEC officials
relied on NASD's representations regarding its
decimal-trading preparations and did not identify
in advance the system limitations that caused
NASD's delay.

     Various challenges remain for the industry as
it progresses toward implementing decimal trading
for all securities yet to be converted to
decimals. Although decimal trading for a selected
number of securities began August 28, 2000, the
securities industry must complete a phased
implementation of all remaining securities,
including Nasdaq-traded stocks, by April 9, 2001
in accordance with a revised order from SEC.  As
part of this, data on how decimal trading is
affecting information system processing volumes,
participant operations, and trading behavior are
to be analyzed before allowing additional
securities to begin trading in decimals. In
addition, the options markets continue to make
limited progress in taking steps to reduce the
message traffic volumes expected to result from
decimal trading and, as a result, intend to
implement decimal trading with higher minimum
price increments than will be used for stocks.
Additional challenges for securities market
participants may arise if all securities listed on
NYSE and the other regional exchanges begin
trading in decimal prices before such trading
begins for Nasdaq-listed securities, but industry
participants indicated that various steps could be
taken to address these challenges.

     This report includes recommendations to SEC
regarding the need for improvements in NASD
systems capacity planning and SEC's oversight of
NASD's preparations for decimal trading.    SEC
and NASD provided technical comments, which were
incorporated into the letter as appropriate.  In
its letter, SEC said that it would be taking
action to implement our recommendation that it
ensure that NASD makes various improvements to its
capacity planning process and intends to consider
our recommendation that it conduct more on-site
examinations of NASD.  In its letter, Nasdaq
stated that its efforts to implement decimal
trading were on schedule; however, Nasdaq objected
to our report's characterization of the way in
which their capacity planning process accounts for
market volatility as a weakness because their
techniques are standard for the industry. However,
although we agree that their trading environment
presents them with a more unique and challenging
task than that faced by other markets, ensuring
that their volume forecasts better incorporate
their trading volume volatility is a key component
for determining whether their information systems
will have adequate processing capacity. Nasdaq
also objected to our draft report's
characterization of the criteria they use for
assessing the adequacy of their system capacities
as inconsistent; in response, we revised our
report to instead indicate that their current
criteria are not effective and refined the
language in our recommendation regarding the
criteria needed.

Background
     Decimal pricing for securities trading is
expected to result in various benefits for U.S.
investors and U.S. securities markets. Trading in
decimal increments should result in smaller
spreads between the prices at which securities are
bought and sold, which should produce savings for
investors. The securities industry, led by the
Securities Industry Association (SIA), has been
preparing to implement decimal trading since 1998.

     In March 2000, we testified on the progress
the industry had made and the challenges that it
continued to face.1 At that time, we cited
adequate systems capacity as being the primary
challenge to the timely implementation of decimal
trading. When decimal trading is implemented,
traders will be able to quote prices using an
increased number of price increments. Currently,
securities prices are usually quoted in increments
of 1/16 of a dollar in the United States, which
provides 16 increments, but quoting prices in
pennies results in up to 100 potential increments.
Having additional price increments is expected to
increase the number of price quotes and executed
trades, which will increase the amount of message
traffic that must be processed by securities
market participants' information technology
systems. In our testimony, we noted that the
greatest increases in message traffic were likely
to be experienced by the Nasdaq market and the
options markets.

Scope and Methodology
     To determine why the Nasdaq market was not
able to implement decimal trading by the initial
SEC-ordered implementation date of July 3, 2000,
we interviewed and obtained extensive
documentation from NASD officials regarding their
approach to implementing decimal trading and their
capacity planning efforts. In addition, we
reviewed external consultant studies on Nasdaq
market capacity planning and technology and SEC
examinations of Nasdaq market information systems.
To understand the approach that NYSE used to ready
its systems for decimal trading, we interviewed
officials and reviewed documentation relating to
the exchange's information technology systems and
capacity planning process.

     To determine how SEC approached the oversight
of the industry's implementation of decimal
trading, we met with SEC officials and reviewed
orders, information technology guidance, and
surveys and examinations of industry participants.
In addition to discussions with SEC officials and
file reviews, we also referred to our past work on
SEC Year 2000 oversight2 to compare the SEC
oversight approach to decimals with its approach
to oversight of industry Year 2000 readiness. We
also interviewed SEC officials, representatives of
securities firms, including online broker-dealers;
electronic communication networks (ECN);3 and a
representative of an investor advocate
organization to obtain their views on any
challenges that remain as part of implementing
decimal trading.  We also reviewed the comment
letters that SEC received from securities market,
broker-dealer, data vendor, and other officials on
the impacts of beginning trading in all securities
listed on NYSE and the other regional exchanges
before such trading began for all Nasdaq market
securities.

     We conducted our work in Washington, DC;
Chicago, IL; and New York, NY; between April and
September, 2000, in accordance with generally
accepted government auditing standards.

Insufficient System Capacity and Unprecedented
Trading Volumes Delayed Nasdaq Decimal Trading
     NASD was unable to meet the July 3, 2000, SEC-
mandated implementation date for decimal trading
because the system it developed to quote decimal
prices lacked sufficient capacity to process the
trading volumes being experienced by its market.
In late 1999 and early 2000, the Nasdaq market
experienced unprecedented increases in trading and
message traffic volumes. In March 2000, NASD
officials announced that the Integrated Quote
Management System (IQMS), which it intended to use
to quote prices in decimals, would not be capable
of processing the message traffic arising from
this increased trading activity.  However, IQMS'
capacity could not be readily expanded because the
initial version that NASD developed was not
capable of using multiple computers.  In addition,
IQMS was written in a programming language that
was less efficient than that used for its existing
quotation system.  The capacity of IQMS also did
not prove to be as adjustable through programming
changes as NASD expected.  Shortcomings in NASD's
approach to capacity planning also contributed to
its inability to meet the original decimal-trading
implementation date because it does not adequately
incorporate the increasing volatility in its
trading volume and it lacks effective criteria for
determining whether its systems have sufficient
excess capacity.  In contrast, NYSE, although
experiencing less of an increase in trading
volume, has information technology systems whose
capacity can be more readily expanded and attempts
to maintain a targeted level of excess capacity.
Rather than designing a new system, NYSE chose to
primarily convert its existing systems to process
decimal prices and reported having made all
necessary changes before the original July
deadline.

Nasdaq Trading Volumes Increased Rapidly in Late
1999 and Early 2000
     In late 1999 and continuing into early 2000,
the Nasdaq market experienced an unprecedented
level of trading activity.  In 1993, the average
number of shares traded daily on the Nasdaq market
was about 263 million.4  By 1996, the Nasdaq
market's average daily shares traded had increased
to about 500 million. Beginning in 1997, trading
volumes on the Nasdaq market began to increase
more rapidly, and it experienced a peak trading
day of over 1 billion shares in October 1997, as
shown in figure 1. By 1999, trading volumes on its
market were averaging about 1 billion shares
daily.

     Subsequently, the Nasdaq market experienced
an even more rapid increase in trading activity.
As can be seen in figure 1, this rapid increase in
trading began in the third quarter of 1999. The
figure also shows that trading volume on the
Nasdaq market increased from an average of about 1
billion shares a day during September 1999 to an
average of 1.8 billion shares during April 2000,
which represents an 80-percent increase in 7
months. NASD officials said that their market had
never experienced growth at such a high rate as
occurred during this period.

Figure 1:  Average Daily and Peak Shares Traded on
the Nasdaq Market, by Month (1997-2000)

Source: GAO analysis of data from NASD.

     Overall, as its trading volume increased, the
amount of message traffic being processed by
Nasdaq's information technology systems increased
even more rapidly. As part of conducting trading
activities, various messages are sent through
Nasdaq's systems among the broker-dealers acting
as market makers in individual securities. These
messages include the price quotes at which they
are willing to buy or sell securities, customer
orders, and reports of executed trades. As shown
in figure 2 below, price quotation message traffic
for the Nasdaq market has increased substantially,
increasing by over 1,121 percent between January
1997 and April 2000. In late 1999, the rate at
which quotation message traffic was growing
increased even more rapidly on the Nasdaq market
because quotation traffic increased by 105 percent
from September 1999 to April 2000.

Figure 2:  Average Daily Quotation Messages on the
Nasdaq Market, by Quarter (1993-2000)

Source: GAO analysis of data from NASD.

     The amount of message traffic that the Nasdaq
market experiences for any given level of trading
volume has increased partly because of changes in
the way that trading on its market is conducted.
Although trading volume and message traffic volume
are generally correlated, a market could
experience a peak in message traffic on a day that
is not a peak trading volume day.  Conversely, a
peak trading volume day may not result in peak
message traffic.  According to NASD officials, a
key reason its overall message traffic has
increased at an even faster rate than its trading
volume is because fewer shares are being bought or
sold as part of each trade. NASD officials
attributed the decline in average trade size to an
increase in the number of individuals investing in
stocks directly, the implementation of the SEC
Order Handling Rules,5 and the increased
popularity of day trading.6  As shown in figure 3,
the average trade size on the Nasdaq market has
consistently fallen since 1994, with about half as
many shares being traded per trade in 1999 as
compared with the 1996 levels.

Figure 3:  Average Shares Per Trade on the Nasdaq
Market (1993-2000)

Source: NASD.

     Although the trading volumes on the Nasdaq
market have declined somewhat since the high
volumes it experienced in early 2000, market
participants expect trading volumes to continue to
increase. After hitting a peak of 2.88 billion
shares on April 4, 2000, trading volumes on the
Nasdaq market averaged about 1.54 billion shares
daily from April 5 until August 4, 2000. However,
trading volumes are expected to increase and
remain volatile. For example, an external
consultant7 that reviewed NASD's information
technology systems said market volume growth and
volatility are likely to increase. NASD officials
agreed that volumes on their market were likely to
continue to increase.

Nasdaq's Decimal Price Quotation System Lacked
Sufficient Capacity
     Limitations in the capacity of the system
that NASD developed to process decimal prices
resulted in its inability to meet the July 3,
2000, deadline for implementing decimal trading.
To disseminate price quotations across its market,
NASD has traditionally relied on a system that
runs on a single-mainframe computer, and this
system successfully processed the unprecedented
trading volumes that Nasdaq experienced beginning
in late 1999.  However, IQMS, which was the system
that NASD was developing to replace this older
system, lacked sufficient capacity to process such
volumes and was not capable of having its capacity
easily upgraded.  Although IQMS is currently being
used to process quotations for some of the trading
being conducted on the Nasdaq market, NASD does
not plan to use it for decimal trading for the
rest of its market and instead is readying its
older system to process decimal prices.

Older NASD System Provided High Level of
Reliability and Capacity Flexibility
     In contrast to NYSE and the other regional
exchanges, the Nasdaq market is a more widely
distributed processing environment.  To conduct
trading on the Nasdaq market, market makers
located around the country enter into the Nasdaq's
computer systems the prices at which they are
willing to buy or sell particular securities.
These price quotations are consolidated by NASD
and displayed to all its members by one system;
trades that are based on these prices are executed
through several other systems.  NASD officials
told us that their various systems currently
process around 3,000 messages per second (MPS).
The system NASD currently uses to process and
disseminate price quotations across its market is
known as its Legacy System.  This system has been
in place since 1971 and was designed to run on a
single-mainframe computer. According to several
external reviews of NASD's technology, Legacy has
provided NASD with a very high level of
reliability and performance.

     Although written to operate on a single-
mainframe computer, NASD has been able to upgrade
Legacy to handle the increasing trading volumes
and volatility occurring on the Nasdaq market over
the years. The mainframe running Legacy has been
replaced several times with more powerful
computers, and the latest upgrade resulted in NASD
using the most powerful machine currently made by
this particular computer manufacturer. In
addition, NASD systems specialists have
continuously expanded Legacy's capacity by making
adjustments to its programming software in a
process called "tuning." The hardware upgrades and
its use of the tuning process has allowed NASD to
increase Legacy's capacity by almost 20,000
percent since 1972.  During the increased surge in
trading volumes in late 1999, NASD officials
reported being able to further increase Legacy's
capacity by 77 percent during a 5-month period.

IQMS Designed With Capacity Limitations
     Although NASD's existing systems have proven
successful, the system NASD designed to replace
Legacy and allow it to process decimal quotations
was not capable of processing the trading volumes
being experienced by its market. IQMS is the
system that NASD designed to replace Legacy.
According to NASD, the development work on IQMS
originally began in 1992, and it was expected to
be implemented by 1994. Unlike Legacy, IQMS is
capable of processing price quotations in decimal
format, and NASD has used this system to process
quotations for the stocks traded on its Over The
Counter Bulletin Board market8 since 1998.

     NASD officials told us IQMS' capacity was
expected to be adequate to process the message
traffic associated with a 2-billion share trading
day, and, in 1992, Nasdaq's trading volumes
averaged about 200 million shares daily. NASD
officials indicated that, at that time, IQMS'
capacity was projected to be greater than that of
Legacy, but the continual tuning adjustments have
allowed NASD to greatly increase the older
system's capacity.  However, NASD experienced
technical problems and other delays in completing
IQMS as originally scheduled. In some cases, NASD
was required to complete other technology
initiatives, such as implementing changes for the
Order Handling Rules and readying its systems for
the Year 2000 date change. According to NASD's
Chief Information Officer, as IQMS was being
developed, the system designers primarily focused
on getting the system to function at the 2-billion
shares per day level and did not revisit the
system's capacity until June 1999.  At that time,
they determined that such a capacity should still
be adequate because average trading volumes were
not projected to exceed that level for several
years.

     The primary reason that IQMS' capacity was
limited was that it lacked the capability of
performing processing across multiple computers.
Using multiple computers to perform processing is
now commonplace among organizations that rely on
large-scale information processing because it
allows additional hardware to be added to systems
as necessary to expand capacity. However, NASD
officials said that the initial version of IQMS
was designed to run only on the same single-
mainframe computer as Legacy, which it was to
replace. NASD officials told us that they
envisioned eventually rewriting the software to
allow it to process across multiple computers or
"load share."

     Because securities trading volumes have
generally increased over time, developing a system
with more flexibility in terms of capacity could
have led NASD to incorporate into IQMS the
capability to load share as part of its initial
design.  NASD officials told us that, at the time
they first considered the design of IQMS, they
analyzed and tested two other computer platforms
that had load-sharing capability.  However,
according to NASD officials, these platforms did
not meet certain performance requirements as well
as the hardware that was used for Legacy and IQMS.
After conducting further testing of IQMS to
determine its processing capacity and considering
the increasing Nasdaq market trading volumes, NASD
decided in June 1999 to develop a second version
of IQMS.

     This second version would have the capability
of distributing processing over additional
computers and provide it with greater capacity
than the initial version. NASD officials indicated
that they had previously anticipated the need to
create such a version of IQMS but had determined
that the system should first be implemented and
proven to be operational before being revised to
allow load sharing.  They also said that
developing an IQMS version capable of load sharing
would be extremely challenging because such
distributed processing capability had not been
accomplished using this particular type of
computer in a large-scale transaction processing
environment like that of the Nasdaq market.  In
addition, NASD officials estimated that creating
this version would require about 18 months; thus,
it would not be ready on the original
implementation date in July 2000. Instead, NASD
planned to use the first IQMS version to begin
decimal trading then and bring the second version
with load-sharing capability into operation later.
However, as previously noted, the volumes in the
market grew too rapidly and NASD officials
determined that, although IQMS could handle the
processing for a 2-billion share day, implementing
it without sufficient reserve capacity would have
been too risky in such a market environment.

     NASD also selected a programming language
that limited IQMS' capacity.  Although IQMS was
written using a more recent programming language
than used for Legacy, NASD officials told us that
they determined that IQMS requires more resources
to process price quotations than would be required
by Legacy. The external consultant that reviewed
NASD's capacity and systems development processes
noted that NASD's systems developers used a
programming methodology and language for IQMS that
were popular when the design of this system began
in 1992. This methodology used a programming
language not commonly chosen for systems today and
also relied on prewritten programming modules to
perform certain standard functions. However, the
external consultant indicated that such a
methodology was an inappropriate choice for a
system that had to handle the large processing
volumes on a real-time basis as was necessary for
IQMS.

     IQMS' capacity also proved to be less capable
of being adjusted through software adjustments. As
previously noted, NASD was able to vastly increase
the processing capacity of Legacy through software
tuning.  In its report on NASD's capacity planning
process, the external consultant noted that NASD's
capacity requirement forecasts assume that it will
continually be as successful at increasing its
systems capacities through tuning as it has been
in the past.  NASD officials told us that they
similarly expected to be able to increase the
processing capacity of IQMS through tuning once it
was operational. After  testing, NASD estimated
that IQMS' capacity could likely be improved by as
much as 30 percent.  However, the initial attempts
to tune the program produced improvements of only
3 percent, which reflected the differences in the
programming languages used in IQMS compared with
the language used by Legacy.

NASD Changed Its Approach to Implement Decimal
Trading
As a result of the capacity limitations in IQMS,
NASD has had to take several actions.  First, NASD
officials told us that, as of July 31, 2000, they
have begun using the initial version of IQMS to
process the price quotations for the exchange-
listed securities that its members trade on its
market.9  This has allowed the Nasdaq market to
process decimal price quotations when such trading
began for selected exchange-listed securities.

To price quotations for its own Nasdaq-listed
securities, NASD officials intended to use the
second version of IQMS that they had begun working
on in June 1999 that would be capable of sharing
processing load across multiple computers.
However, NASD had also begun working on rewriting
the Legacy System to give it the capability of
processing decimal quotations.  In May 2000, NASD
decided to curtail further development of the
second version of IQMS.  NASD officials said that
they chose this course of action because they
could get better capacity performance with Legacy
than with IQMS. Because they will not be
continuing to prepare IQMS to process decimal
quotations for trading for the rest of the Nasdaq
market, these officials expected that the
rewriting of Legacy would be complete during the
first quarter of 2001 in time to meet the SEC's
planned implementation date. NASD also intends to
implement a new system sometime in 2001 that will
replace Legacy, operate on multiple computers, and
have more advanced capabilities than its systems
currently possess.

NASD Capacity Planning and Systems Development
Does Not Adequately Incorporate Trading Volatility
     Shortcomings in NASD's capacity planning
process also contributed to its inability to be
ready for the original decimal-trading deadline.
NASD uses a forecasting methodology that has
worked well in the past but does not sufficiently
consider the recent volatility in its market's
trading volume. Moreover, it lacks effective
criteria for ensuring that its systems have
sufficient excess systems-processing capacity,
given its volatile market.

Forecasting Methodology Does Not Adequately
Incorporate Trading Volatility
     A shortcoming exists in the approach that
NASD uses to forecast its future trading and
transaction volumes. NASD officials told us that
they annually develop forecasts of the trading
volumes that are likely to be experienced by the
Nasdaq market over the next 3 years. The
forecasting model used to project trading volume
is based on historical trading activity over the
last 36 months.  Using the output of this model,
NASD forecasts estimates of the expected average
and peak transaction volumes. It also calculates a
likely range for these estimates, including a high-
and-low expected value for each estimate. These
estimates are also updated monthly to account for
current market activity.  According to these
officials, this methodology has been very
successful, as NASD actual peak volumes have
exceeded its predicted values only twice in 20
years.

     However, trading and message traffic volumes
on the Nasdaq market have become more volatile in
recent years.  As previously shown in figure 1,
trading volumes on Nasdaq began to be more
volatile starting in late 1997.  For example, NASD
officials said that the surge in trading activity
in 1999 that prevented them from implementing
decimal trading was unprecedented, and, therefore,
they had no basis to expect such trading activity
to occur.

     However, according to the external
consultant's study of NASD capacity planning,
NASD's forecasting methods, although standard for
the industry, do not adequately take into account
this more recent volatility in the trading
activity on the Nasdaq market. In its report, this
consultant described a new technique that could
potentially be used to improve the forecast NASD
produces of its expected trading volumes because
it places greater emphasis on more recent trading
activity than does NASD's current methodology.
The consultant's report uses this technique to
project NASD volumes for 3 months into the future.
However, NASD officials told us that the technique
in the consultant's report would require
additional refinement to determine if it could be
used to create forecasts of sufficient length to
be useful for systems capacity planning purposes.

NASD Lacks Effective Criteria for Ensuring That
Its Systems Have Sufficient Excess Capacity
     NASD's capacity planning process also lacks
effective criteria for determining whether the
information systems it currently uses and those
under development have sufficient excess
processing capacity.  NASD officials explained
that they use the forecasts of expected
transaction volume to ensure that the actual
processing capacities of their systems are
adequate to meet the highest level of these
expected volumes, and they have had considerable
success using this method.  However, NASD
officials acknowledged that they need to develop a
better means of assessing the adequacy of their
systems' processing capacities given the increased
volatility and rapid growth in their trading
volume.

     Developing criteria for assessing whether
information systems have adequate excess
processing capacity is an increasing challenge for
all organizations active in the securities
markets.  The amount of excess capacity in
information technology systems can vary widely
depending on the type of processing that is
required and the speed at which information can be
sent into such systems.  The demands placed on
systems used in the financial markets can be
particularly high as market conditions or external
news events can create unpredictable surges in
trading volumes.  However, SEC officials told us
that no standard criteria for making such
determinations currently exist for the securities
industry.  Some organizations attempt to maintain
excess capacity levels at set multiples above
their forecasted peak volumes. NASD officials
indicated that they do not use similar multiples
of their forecasted peak, although they estimated
that they maintain levels of excess capacity that,
at times, are comparable to those of organizations
that do use such targets.  However, given the
volatility of their trading and the structure of
their market, which can result in more extreme
surges in trading activity than usually occurs on
other markets, NASD officials said that the means
they use to assess the adequacy of excess capacity
in their current and new systems will have to more
effectively reflect these differences. Having such
criteria and applying them during IQMS'
development may have also indicated the capacity
shortcomings of that system, such as when the
Nasdaq market's trading volume peaked on October
28, 1997, with over 1.3 billion shares.  At that
point, IQMS' capacity was less than 2 times this
peak.

     Concerns had also existed that NASD's
capacity planning efforts had not adequately taken
into consideration the expected impact of decimal
trading on message traffic volumes. In April 1999,
a study was completed by SRI Consulting on behalf
of SIA that estimated the impact that decimal
trading would have on industry information systems
processing volumes.10 In its study, SRI projected
that quotation volumes on the Nasdaq market would
increase by as much as 231 percent by year-end
2001 over their 1998 levels following the
implementation of decimal trading if minimum price
variations (MPV) were a penny. In addition, in our
March 2000 testimony, we noted that SRI had
revised its estimates upward in February 2000, to
project increases in quotation volume on the
Nasdaq market as much as 700 percent by year-end
2001 from the 1998 levels due to increased market
trading activity.

     NASD officials had initially indicated that
the projections in SRI's decimals capacity study
were not accurate for its market systems. Instead,
they indicated that their own research was more
appropriate for estimating the impact of decimal
trading on their market. Using these projections,
NASD officials told us that they expected that
their IQMS system would have had adequate capacity
to process the additional traffic resulting from
decimal trading. However, as previously noted, the
growth in trading on Nasdaq's market exceeded
expectations; thus, NASD had to postpone its
implementation of decimal trading. However, NASD
has recently contracted with SRI to produce
forecasts of the impact of decimal trading on the
processing volumes for the Nasdaq systems that
better incorporate the specifics of their
operations.  NASD officials told us that these new
projections are much lower than the original study
predicted.  However, we were not able to review
the methodology and these results in detail before
the publication of this report.

SEC Has Also Raised Concerns Regarding NASD
Capacity Planning Process
     SEC has also raised concerns over aspects of
NASD's capacity planning process.  According to an
SEC official responsible for conducting
information system reviews, NASD has had capacity-
related problems since 1992.  SEC has also noted
these concerns in reviews done in recent years.
For example, in a 1997 review of Nasdaq market
systems, SEC staff expressed concerns about the
ability of Nasdaq market systems to sustain
acceptable levels of service during periods of
sudden and extreme surges in transaction and
quotation volume. At the time, SEC was
anticipating greater message traffic volumes on
the Nasdaq market as a result of the
implementation of the Order Handling Rules, the
advent of ECNs, and the effects of smaller MPVs.
According to NASD officials, they had developed a
plan and had begun to upgrade and expand their
systems' capacities to address these concerns.
In its report, SEC recommended that the Nasdaq
market accelerate these efforts, and NASD
officials told us that they took various steps at
that time to increase the capacities of their
various systems.

     After conducting another review of NASD
systems in the summer of 1999, SEC issued a report
in January 2000. In this report, SEC expressed
concerns that Nasdaq's systems would not have
sufficient capacity to sustain acceptable service
for current and projected levels of message
traffic, which were expected to further increase
following the implementation of decimal pricing.
As a result of this concern, SEC recommended that
the Nasdaq market obtain an external review of its
capacity planning process that would be reported
to the NASD governing board by June 30, 2000. NASD
received the final version of the report completed
by this external consultant in June and has been
reviewing and considering the study's
recommendations.  Although the consultant
confirmed IQMS' capacity limitations and NASD's
shortcomings in its capacity planning, it also
reported that NASD exceeded industry standards in
several areas, including systems reliability and
in stress-testing capabilities.

     NASD has also undertaken various other
improvements to expand its system capacities.  For
example, NASD upgraded the capacity of its
enterprisewide communication network.  In
addition, NASD replaced the mainframe computer it
uses for quotation processing in October 1999 to
the largest unit offered by that manufacturer.
NASD also implemented new, multimessage switch
architecture in the first quarter of 2000 that
doubled its message-switching capacity.

NYSE Had a Different Approach to Readying Its
Systems for Decimals and for Capacity Planning
     The processing environment differs for NYSE
and its approach for preparing for decimal trading
also differed from that of NASD.  According to
NYSE officials, their systems have been ready for
decimals since April 2000, and NYSE was prepared
to implement decimal trading by the initial
deadline of July 3, 2000. NYSE officials told us
that their approach to converting their systems
for decimals was similar to the approach they took
for correcting Year 2000 flaws in their systems.
They said that in most cases, they programmed
their existing trading systems to process decimal
prices, rather than creating new systems with
decimal-trading capabilities, which allowed them
to ready their operations fairly quickly.

     NYSE's market structure, processing
environment, and approach to capacity planning
also differs from that of NASD. With a widely
distributed network of market makers, NASD uses a
single-mainframe architecture to consolidate and
process price quotations.  In contrast, NYSE's
operations are centralized on a single trading
floor.  NYSE officials told us that their trading
and quotations systems have used a computer
architecture that allows processing to be
performed on multiple computers since about 1978.
Such an approach allows NYSE to add additional
computers, as necessary, to expand capacity.

     NYSE also uses various targets that are
multiples of its current trading volumes as
criteria for ensuring that it has sufficient
excess processing capacity.  In a June 2000 U.S.
House of Representatives testimony, NYSE reported
that it can handle transaction rates of 1,000 MPS,
which equates to about a daily trading volume of 5
billion shares.11  NYSE officials said that recent
capacity modeling has indicated that their
system's maximum capacities may be reduced below
these levels, depending on how decimal trading
affects message traffic levels.  By the end of the
year, NYSE plans to double its systems' capacity
to about 2,000 MPS.  In contrast, the Nasdaq
market's systems are reportedly already processing
3,000 MPS, and NASD officials said that they plan
to expand these rates to be 3 to 6 times these
levels.

NYSE's systems development and capacity planning
approach reflects its experience with periods of
high trading volumes. During the 1987 market
crash, high trading volumes occurred on NYSE,
NASD, and the other U.S. markets. All markets
experienced problems in their information
technology systems, including NYSE.12 As a result,
NYSE made various changes, including expanding its
systems' capacities. During the recent period of
increased trading volume that began in late 1999,
NYSE's systems performed as expected, although it
did not experience as much of an increase as the
Nasdaq market. NYSE's trading volume increased
from averaging about 780 million shares a day in
September 1999 to an average of 1.1 billion shares
during March 2000, which represents a 45-percent
increase in 6 months. By contrast, average volumes
on the Nasdaq had increased by 80 percent during
this period.

SEC's Decimal-Pricing Oversight Similar to Its
Year 2000 Approach
SEC has overseen the securities industry's
implementation of decimal pricing using a similar
approach to its oversight of the industry's
readiness for the Year 2000 date change. As it did
for that effort, SEC has primarily relied on
industry participants to report their readiness
status and has conducted on-site examinations of
selected market participants. Although SEC
conducted various reviews of NASD that raised
capacity concerns, SEC officials relied on NASD's
representations regarding its decimal-trading
preparations and did not identify in advance the
system limitations that caused NASD's delay.

SEC Has Specific Group That Reviews Information
Technology Issues
Within SEC, various groups are responsible for
oversight of the securities industry. Since 1991,
SEC has had a small group within its Division of
Market Regulation that oversees information
technology issues for the exchanges, NASD, and
clearing organizations.   This group is
responsible for administering SEC's Automation
Review Policy (ARP). Under the ARP program, SEC
has issued guidance to the self-regulatory
organizations (SRO) in the industry regarding
their information technology systems. This
guidance addresses various issues, such as
capacity planning, systems development, and
information security. The guidance also indicates
that SEC expects SROs to have external reviews
done of their information systems. SEC did not
initiate the ARP program under its rule-making
authority; thus, the program guidance is only
voluntary for SROs.

SEC officials said that in addition to performing
reviews related to this guidance, SEC's ARP group
also monitors information systems issues at SROs,
including tracking changes to systems and
reviewing rule filings related to automation
issues.  The ARP group currently has a staff of
eight, all of whom have information technology
backgrounds as well as other training.

In addition to the SRO reviews conducted by the
ARP staff in SEC's Market Regulation Division,
other SEC staff also are involved in overseeing
information technology issues for the securities
industry.  SEC's Office of Compliance Inspections
and Examinations (OCIE) conducts regular reviews
of broker dealers, investment advisers, and other
market participants on a variety of issues that
sometimes address these firms' information
technology systems.

SEC Set Various Deadlines for Decimal
Implementation and Surveyed Industry Participants'
Readiness
As was the case in the industry's preparations for
the Year 2000 date change, SEC's initial efforts
regarding decimal pricing involved increasing
awareness and assisting in establishing standards
and approaches for implementation. Beginning in
1997, SEC organized several meetings with various
market participants to address such issues as
developing industry standards and strategies for
implementing decimal trading. For example, these
discussions addressed various topics, such as the
appropriate number of decimal places that
information technology systems should be capable
of processing.

Similar to the milestones it set for its Year 2000
effort, SEC directed the exchanges and NASD to
take specific actions and established various
deadlines for the industry to meet as part of
their efforts in implementing decimal pricing. In
September 1999, SEC issued an order to the
participants in the options markets requiring them
to work cooperatively on options quotation message
traffic issues that are expected to arise as a
result of decimal trading.13 In January and June,
2000, SEC also issued orders directing the
exchanges and NASD to work together to prepare
implementation plans designed to ensure that the
industry implemented decimal trading according to
the specific time frames designated in these
orders.14

As part of overseeing the securities industry's
Year 2000 efforts, SEC required various market
participants, including exchanges, broker-dealers,
and others, to periodically provide reports
directly to SEC on the progress of their efforts
to ready their systems for the date change. SEC
advised broker-dealers that failure to adequately
ready their system to correctly process date-
related information after January 2000 would be
considered a violation of the requirements for
such firms to maintain accurate customer records.

SEC has similarly required certain market
participants to report on their progress toward
preparing for decimal trading.  The ARP staff
surveyed the exchanges and NASD regarding their
efforts to ready their systems to accommodate
decimal trading. These surveys were conducted in
January and July, 2000.  To ascertain the
readiness of broker dealers for decimal trading,
OCIE staff worked jointly with NYSE and NASD to
prepare surveys that SROs were to administer to
their members.

SEC Also Has Conducted Examinations of Decimal-
Trading Readiness
     In addition, SEC has also conducted
examinations to review the readiness of selected
industry participants for decimal trading.  To
assess Year 2000 readiness, OCIE staff had
initially conducted on-site examinations of broker-
dealer firms using a module containing a brief
series of questions.  In 1999, it conducted a more
detailed series of on-site examinations of about
30 firms in conjunction with staff from various
SROs.  To review the readiness of SROs themselves,
ARP staff conducted on-site reviews that also
addressed Year 2000 issues as well as other
matters of all SROs at least once. During 1999,
SEC also required SROs to submit monthly surveys
regarding their progress, and ARP staff used these
to select SROs for additional on-site
examinations.

     Regarding decimal trading's implementation,
SEC has also conducted an on-site examination
effort as it did to ensure Year 2000 readiness.
To assess the readiness of broker-dealers, SEC's
OCIE staff conducted on-site examinations of a
selected number of broker-dealers beginning in
February 2000.  Since the new implementation date
was established in SEC's June 2000 order, OCIE
staff have again worked with SROs to plan a joint
series of examinations to follow up on the surveys
administered by the SROs.  To conduct this effort,
an SEC official told us that staff from SEC, NYSE,
NASD Regulation, and the Chicago Board Options
Exchange have jointly developed an examination
module and participated in joint training.  These
organizations plan to examine a total of 28 broker-
dealers, including a majority of the most active
trading and clearing firms for stocks and options.
Corresponding to various checkpoints in the
industry's phased implementation of decimal
trading, the preliminary results of these
examinations are to be reported by mid-September,
and the final results are to be completed by late
October.  OCIE officials told us that this effort
has been modeled on the reviews conducted in 1999
assessing the Year 2000 readiness of large broker-
dealers.

     During 2000, SEC ARP officials told us that
they have conducted examinations that addressed
decimal issues at 9 of the 14 SROs that must ready
their systems for decimal trading. These
examinations were part of the regular ARP
inspections of these organizations' information
technology and also address other issues beyond
decimal-trading readiness. According to an SEC
official, fewer examinations have been conducted
focusing on decimal readiness because SEC's
resources were initially committed to ensuring
participants' readiness for the date change in
2000, which they viewed as a serious risk to
market operations.

     Although SEC has raised concerns relating to
NASD's systems capacities, SEC staff relied on
NASD officials' representations about the progress
being made to ready the Nasdaq market's systems
for decimal trading and did not identify in
advance the system limitations that caused NASD's
delay. As previously noted, SEC had conducted a
recent examination of NASD that addressed various
aspects of NASD's operations, including its
capacity preparations for decimal trading. This
examination work was conducted over a period of 8
days in July, August, and September, 1999, and SEC
issued the report that was based on this work in
January 2000.  In its report, SEC expressed
concerns about NASD's systems capacity in light of
the likely increased volumes expected from decimal
trading and recommended that an independent review
of NASD's capacity planning process be performed.15
In late February 2000, SEC received NASD's
response to the first survey SEC had sent to all
markets regarding their decimal readiness, in
which NASD indicated that its decimal efforts were
on schedule. However, within 2 weeks, NASD
announced that it would be unable to meet the
expected implementation date of July 3, 2000.

Industry Faces Various Challenges in Preparing for
Decimal Trading
     Although the first phase of decimal trading
began August 28, 2000, only a small percentage of
securities were converted to decimals, and various
challenges remain for the industry as part of
implementing such trading for all securities. As
required by SEC, the relevant participants
submitted a plan for implementing decimal trading.
During the phased-in implementation outlined in
this plan, the participants are to collect and
analyze information on (1) the effects of decimal
trading on industry participants' systems
operations and (2) the functioning of market rules
to ensure that the industry is ready for the next
phase in the implementation. The options exchanges
will have to continue to work on addressing the
capacity concerns facing their markets. Finally,
market participants will have to prepare to
mitigate the effects on the markets if the decimal
trading of all exchange-listed securities begins
before such trading for Nasdaq market securities.

Industry Participants Are Preparing to Implement
Decimal Trading
     In June 2000, SEC issued its latest order16
that required the securities exchanges and the
Nasdaq market to prepare a plan to begin
implementing decimal trading by September 5, 2000.17
SEC's order also required that such trading be
implemented for all securities by April 9, 2001.
On July 24, 2000, the relevant market participants
submitted the industry's implementation plan to
SEC in response to the SEC order. As shown in
figure 4, the industry plans to implement decimal
trading over four phases. The first phase, which
involves the trading of a limited number of
exchange-listed securities, began on August 28,
2000.  As indicated in the figure, in November
2000, the market participants intend to consider
allowing all exchange-listed stocks and their
corresponding options to begin trading in decimals
while Nasdaq market stocks are trading in
fractions.  If approved, such trading would begin
30 days later in December.

Figure 4:  Planned Phases for Implementation of
Decimal Trading

Source:  GAO analysis of securities market
participants' plan for decimal implementation.

     As part of implementing decimal trading under
this phased-in approach, the plan submitted by the
securities market participants indicates that they
intend to collect and analyze information during
the various phases. This information is to be used
to determine how decimal trading is affecting the
operations of participants' information systems,
including the impact on these systems' capacities.
In addition, the participants intend to determine
how the implementation of decimal trading has
affected trading behavior, and this information is
to be used as the basis for determining if any
changes to exchange or market rules are required.
Before the beginning of each subsequent phase of
the implementation, the market participants will
convene and determine whether the industry is
ready to begin the next phase. Overall, the
industry's plan indicates that at a minimum of
five points in time, its representatives expect to
confer with SEC about their readiness to proceed
to the next phase.

Options Markets Have Made Limited Progress on
Capacity Issues
     As we testified in March 2000,18 the options
markets have faced a considerable challenge in
preparing for decimal trading. The system that
transmits the options market quotations, which is
administered by the Options Price Reporting
Authority (OPRA), had experienced a peak of about
3,500 MPS as of August 8, 2000.  Efforts are under
way to expand the OPRA system's capacity to 12,000
MPS by December 2000.  However, the consultant
that performed the capacity study for the industry
indicated that options message traffic could reach
38,000 MPS by the end of 2001 after decimal
trading is implemented.

     Because of the potential that the message
traffic arising from decimal trading could exceed
the OPRA system's capacity, the implementation
plan submitted by the various market participants
maintains minimum price increments for options
trading of between 5 and 10 cents, depending on
the price of the underlying stock. These
increments are higher than those for stocks, which
will trade in penny increments.  If lower
increments were used, the OPRA system would not
have sufficient capacity because too many
quotation messages would be automatically
generated by the computers that options market
makers use to produce their options price quotes.

     In response to the concerns over the OPRA
system's capacity, the various options markets
have also been cooperating with one another to
develop strategies for reducing message traffic
levels. However, these efforts have made limited
progress to date. Currently, the options markets
participants have agreed to allocate the capacity
of the OPRA system among themselves during peak
periods.  This allocation is based primarily on
the historical peak volume of each market.

     However, SEC has urged the options markets to
develop a more equitable allocation method. Using
an allocation that is based on historical peak
volume results in more allocation being awarded to
exchanges that historically produced more
quotations, regardless of whether these quotations
lead to actual trades. Therefore, SEC has sought
comments on its own alternative means for
allocating the OPRA system capacity during peak
usage periods.19 The alternatives that SEC proposed
are designed to provide incentives for the options
markets to reduce excessive quoting and would
reward those exchanges that quote more efficiently
with a larger allocation of the total transmission
capacity of the OPRA system.

Steps Could Be Taken to Address Challenges of
Implementing Decimal Trading for Exchange-listed
Securities Before NASD Listings
     Although acknowledging that securities listed
on NYSE and the other regional stock exchanges
could begin decimal trading before those listed on
the Nasdaq market, the market participants that
responded to SEC's request for comments, generally
did not support such an approach. The primary
issues they raised included investor confusion,
systems capacity concerns, and increased potential
for order entry and other errors. However, market
participants also indicated that steps could be
taken to mitigate these concerns.

     After NASD announced it's inability to meet
the originally scheduled July 2000 date, some
proponents called for decimal trading in all
exchange-listed securities to proceed even though
NASD would not be ready to begin such trading in
its own listings until the first quarter of 2001.
In seeking market participant input on the revised
decimal-trading implementation milestones, SEC
referred to such trading as "dual pricing."
Although some trading of exchange-listed
securities is also conducted by NASD market makers
using NASD systems, NASD officials have indicated
that the systems used for such trading could be
decimal-ready by September 2000, which would allow
dual pricing for exchange-listed and Nasdaq
securities to begin.

     The securities industry market, broker-
dealer, data vendor, and other officials that
provided written comments to SEC, and those that
we interviewed, generally acknowledged that it
would be technically feasible to begin trading in
exchange-listed securities using decimal prices
before such trading began for those securities
listed by Nasdaq. However, many participants
indicated that if a dual-pricing approach is
implemented, trading in the same security in both
fractional and decimal prices should be avoided.
This concern arises because some securities are
traded on more than one exchange or market.
According to these officials, the reasons that
such trading should be avoided included arbitrage
on the basis of different price increments,20
investor confusion, and the prevention of industry
systems processing limitations. The potential for
problems arising from having the same security
being traded in both fractional and decimal
increments has been reduced as NASD officials have
indicated that the systems that it uses to support
the decimal trading of those exchange-listed
securities traded on its market are currently
decimal-ready.

     Although acknowledging that decimal trading
for all exchange-listed securities could begin
first, most industry participants raised various
issues with such an approach. The most frequently
cited issue was that having all exchange-listed
securities trade in decimals while those listed on
the Nasdaq market traded in fractions would be too
confusing to investors. However, two data vendors
and two ECNs we spoke with indicated that investor
confusion was not likely to be a major problem.
For example, officials from one of the ECNs told
us that decimal pricing instead should reduce
confusion because it is a more rational pricing
format and is used in other world markets.

     To address possible investor confusion, some
market participants suggested that an educational
campaign for investors addressing decimal trading
in a dual-pricing environment would be required.
SIA officials advised SEC that educating investors
about dual pricing would require a major campaign.
SIA has already developed various literature and
press release language that it plans to issue and
that can be used by other market participants to
help educate their own customers about the
transition to decimal trading.

     Some market participants also opposed rapidly
moving to a dual-pricing environment in the
securities markets because of concerns over
whether information technology systems would have
adequate capacity. For example, the Chicago Board
Options Exchange commented to SEC that the impact
of decimal trading on systems capacity was likely
to be enormous. Therefore, the Chicago Exchange
warned that moving too quickly to having all
exchange-listed and Nasdaq securities trading with
dual pricing would (1) prevent the industry from
measuring the impact of decimal trading in a
controlled environment and (2) reduce the
exchange's ability to take remedial actions before
its systems were overwhelmed. Officials from the
Securities Industry Automation Corporation, which
is the organization that performs information
system processing for NYSE, the American Stock
Exchange, and the systems that link the stock and
options markets, told us that the industry already
is facing a considerable challenge in addressing
increased trading volumes. As a result, they
suggested that waiting to implement decimal
trading for all securities until 2001 could
provide all market participants with more time to
better prepare for the additional volumes expected
to result from decimal trading.

     However, as previously discussed, the
industry plans to implement decimal trading in
phases and does not envision allowing all exchange-
listed securities to trade in decimals until
December 2000 or later, thus reducing the length
of time during which the markets would be trading
under dual pricing. This additional delay in
implementing such trading would provide more time
for market participants to increase the capacities
of their information systems. In addition, the
industry's plan described above also envisions
analyzing the impact of decimal trading on market
participants' information systems capacities as
part of determining whether to move to the next
phase of the implementation plan.

     Market participants also expressed concerns
that a dual-pricing approach would increase order
entry and other operational errors. One broker
dealer firm indicated that dual pricing would be
confusing for its traders, and that errors made as
a result of dual pricing would affect customer
confidence. One particular area in which
participants indicated that dual pricing could
increase errors involved investors' entering
orders through on-line trading systems.21  For
example, a broker-dealer firm commented to SEC
that investors may experience problems in
conducting trades if they use the wrong pricing
format for an order that is later rejected by the
market for that security.

     Although a dual-pricing trading environment
could potentially increase operational errors,
some steps could be taken to reduce their
occurrence. For example, broker-dealers that
accept customer orders using on-line trading
systems could program these systems to immediately
inform customers entering orders if they use an
incorrect pricing format.

     Although most participants expressed concerns
about an approach involving dual pricing for all
securities, some indicated that having decimal
pricing begin for exchange-listed and other
securities as soon as possible would accelerate
the benefits anticipated to result from decimal
trading. These officials indicated that rapidly
implementing decimal trading would reduce the
delay in realizing the reduced spreads and other
benefits to investors expected from decimal
trading. However, some participants noted that
investors would receive the greatest benefit when
all Nasdaq securities are trading in decimals
because most trades in exchange-listed securities
do not involve the payment of a spread to a broker-
dealer.

Conclusions
     Although the Nasdaq market experienced an
incredible surge of trading volume beginning in
late 1999, it was able to process the resulting
increased volumes with its existing systems.
However, the system NASD developed to process
decimal prices for its market had insufficient
capacity to process the trading volumes the market
was experiencing.  The primary limitation
affecting the capacity of this system was its
inability to use multiple computers to conduct
processing.

     In recent years, trading and message volumes
on the Nasdaq market have grown substantially and
have become more volatile.  However, NASD's
methodology for forecasting such trading volumes
and message traffic has not changed to reflect the
increasing volatility of this trading.  As a
result of this new environment, NASD officials
acknowledged the need to develop better criteria
for determining whether their information systems
have sufficient excess capacity in light of their
market's trading volatility and how quickly they
can expand processing capacity.  If NASD had such
criteria and applied it during the development of
IQMS, the capacity-related limitations of this
system may have been apparent earlier, such as
when it experienced a peak trading day in 1997
with volume exceeding 1 billion shares.

     SEC has overseen the securities industry's
progress toward implementing decimal trading using
an approach similar to the way it oversaw the
industry's efforts to prepare for the Year 2000
date change. As it did for the Year 2000 effort,
SEC relied largely on industry participants to
report their progress in readying their systems
for decimal trading but also conducted
examinations of various market participants
regarding their readiness for decimal trading.  In
conducting its oversight of NASD, SEC generally
relied on NASD's representations of the progress
being made to ready that market's systems for
decimal trading.  However, SEC did not determine
in advance that NASD's systems development efforts
would not successfully produce a system that would
have adequate processing capacity for decimal
trading in time to meet the original
implementation deadline. Given NASD's recent
decision to modify its existing Legacy System to
accommodate decimal pricing, additional on-site
examinations of its progress on this revised
strategy appear to be warranted.  On-site
examinations could provide SEC with greater
assurance about the specific steps NASD is taking
to implement decimal trading in accordance with
the SEC-mandated plan, including allowing it to
better ensure the validity of representations made
by NASD officials.

     Although decimal trading has begun for a
small number of securities, various challenges
remain for the securities industry as part of
fully implementing such trading for all
securities. The industry participants have a
revised schedule to meet and all securities and
all markets are to be trading in decimals by April
9, 2001. Over the course of the phased
implementation, the market participants will also
have to collect and analyze sufficient data to
assure themselves and SEC that the industry is
ready for each subsequent phase. This analysis is
to ensure that market participants' systems have
adequate processing capacity and are operating
properly. In addition, the participants will have
to assess whether market regulations are still
functioning as intended in the trading environment
involving decimal prices.

Recommendations
     We recommend that the Chairman, SEC, take
steps to ensure that NASD develops

ï¿½    a volume forecasting methodology that better
incorporates the volatility of the Nasdaq market's
trading environment,
ï¿½    systems that are capable of being quickly
expanded to handle increased processing levels,
and
ï¿½    criteria for determining the minimum amount
of excess capacity to be maintained for both
existing and planned information technology
systems that adequately consider its market's
trading volatility and speed at which its systems'
capacities can be expanded.
The Chairman should also direct SEC staff to
conduct more on-site examinations of NASD as a
means of collecting and verifying additional
information on that market's progress in
implementing decimal trading in accordance with
the current implementation schedule.

Agency Comments and Our Evaluation
We requested comments on a draft of this report
from the heads, or their designees, of SEC and
NASD.  These organizations provided us with
written comments, which appear in appendixes I and
II, and also with additional technical comments
that were incorporated into this report as
appropriate.

In its letter, SEC described the role it has
played in supporting and overseeing the industry's
progress. SEC stated that our recommendations
regarding NASD's systems capacity planning
processes were consistent with issues SEC has
identified relating to NASD's systems capacities.
To address this portion of our recommendation, SEC
said they would review the consultant's
recommendations to NASD and track NASD's
implementation of these recommendations.  As long
as this results in NASD making the improvements to
their volume forecasting and systems development
processes called for in our recommendation, this
appears to be a reasonable approach.

SEC said it intends to consider our recommendation
that it conduct more on-site examinations of
NASD's decimal-trading efforts, but noted that we
did not identify what additional information could
be obtained through more on-site examinations of
NASD.  In its letter, SEC acknowledges that on-
site examinations are an important element of its
ARP program but that it does not primarily rely on
them, and it questions whether such an approach
would be an effective use of government resources.
Although we understand the approach SEC has taken
with its ARP program, we believe that there are
benefits to be gained from additional on-site
examinations of NASD.  As we noted in this report,
although SEC conducted some examinations of the
Nasdaq market's readiness for decimal trading, it
also relied on NASD officials' representations of
their organization's progress as part of its
efforts to monitor NASD's readiness. Such
representations indicated that NASD's decimal-
trading implementation efforts were on schedule up
until the public announcement that it would not be
ready.

On-site examinations would provide SEC
opportunities to verify, corroborate, and more
thoroughly evaluate NASD's progress and readiness.
As noted in our published auditing standards,22
evidence obtained through direct physical
examination, observation, computations, and
inspection is more competent than evidence
obtained indirectly.  Regarding SEC's concern over
whether additional examinations would be an
effective use of government resources, the amount
of resources required to complete such
examinations should be minimal and likely assist
in their oversight efforts to a greater degree
than activities currently being undertaken by SEC
staff.  Nevertheless, to address SEC's comments,
we have modified our conclusions and
recommendation to more specifically discuss what
we believe SEC would gain from conducting such
examinations.

In its letter, NASD stated that the efforts it is
making to implement decimal trading are on
schedule.  NASD also stated that our report
incorrectly characterized as a weakness the way in
which its capacity planning process accounts for
the volatility of trading volumes on its market.
It indicated that referring to this as a weakness
implies that it can be remedied, but it stated
that accurately predicting the future is
notoriously difficult for any organization.  NASD
further noted that it uses techniques standard for
the industry but faces a harder task because its
market has experienced greater volume growth and
greater volatility than other markets.

We agree that the trading environment and market
conditions of the Nasdaq market present a
difficult challenge for NASD in developing
accurate forecasts of its future trading volumes
and accompanying message traffic loads.  However,
ensuring NASD's continued operations will require
it to enhance the techniques it employs to better
account for the circumstances of its market.  Our
report describes a possible technique developed by
the external consultant that reviewed NASD's
capacity planning process that may serve as the
basis for incorporating its market's trading
volume volatility into its methodology for
projecting future volumes.  We also acknowledge
that this technique will require further
development before it could be used to generate
forecasts of sufficient length to be useful to
NASD.  In exploring this area, NASD may find that
some other techniques may prove even more
applicable.  Nevertheless, the soundness of its
market operations depends in part on being able to
more accurately forecast future trading volumes so
as to ensure that it has adequate processing
capacity to accommodate such trading activity and,
as discussed in the next paragraph, to assist in
identifying an adequate level of excess capacity
to maintain.

In response to our recommendation that NASD
develop consistent criteria for determining how
much excess processing capacity to maintain,
NASD's letter stated that the criteria it
currently uses to size its systems are consistent.
It indicated that, instead, its shortcoming could
be addressed if it developed a method for
calculating the need for excess capacity that
incorporates its market trading volume volatility
with the capabilities of its system architecture.
We agree that the methodology that NASD officials
described to us is consistent, and we have revised
the text of this report to indicate instead that
NASD lacks effective criteria for ensuring that
its systems have sufficient excess capacity.

We have also revised the language of the
recommendation to indicate the need for NASD to
develop criteria that consider its market trading
volatility and the speed at which its systems'
capacities can be expanded as discussed in a
September meeting with NASD officials.  As
previously noted, NASD faces a considerable
challenge in predicting its future trading volumes
and implementing systems that can accommodate the
growth and volatility of its market.  The criteria
that NASD uses to assess whether it has sufficient
excess capacity in its systems will have to
reflect the increasingly volatile nature of its
market's trading.  In addition, the flexibility
and speed at which NASD can expand its systems'
processing capacities will also affect the
criteria that it develops.  Using the less-
flexible mainframe architecture on which it has
traditionally relied for processing price
quotations will require NASD to plan for larger
amounts of excess capacity because expanding the
capacity of such architecture is more expensive
and requires more time.  As NASD transitions to
architectures that are more readily capable of
using multiple computers to perform processing,
the need for larger amounts of excess capacity
will likely be reduced.

As agreed with you, unless you publicly release
its contents earlier, we plan no further
distribution of this report until 30 days from its
issue date. At that time, we will provide copies
to Representative W.J. "Billy" Tauzin, Chairman,
Subcommittee on Telecommunications, Trade, and
Consumer Protection, House Committee on Commerce;
Representative John D. Dingell, Ranking Minority
Member, House Committee on Commerce;
Representative Edolphus Towns, Ranking Minority
Member, Subcommittee on Finance and Hazardous
Materials, House Committee on Commerce;
appropriate congressional committees; Arthur
Levitt, Chairman, SEC; Frank G. Zarb, Chairman and
Chief Executive Officer, NASD; and Richard A.
Grasso, Chairman and Chief Executive Officer,
NYSE. We will also make copies available to others
on request.

Key contributors to this report are acknowledged
in appendix III. If you have any questions, please
call Thomas M. McCool at (202) 512-8678.

Thomas M. McCool
Director, Financial Institutions
 and Markets Issues

Keith Rhodes
Director, Computer and Information
 Technology Assessment
_______________________________
1 Securities Pricing: Progress and Challenges in
Converting to Decimals (GAO/T-GGD-00-96, Mar. 1,
2000).
2 SEC Year 2000 Report: Future Reports Could
Provide More Detailed Information (GAO/GGD/AIMD-98-
51, Mar. 6, 1998).
3 ECNs are generally privately operated, screen-
based electronic systems that allow customers to
enter orders that are displayed to other customers
and executed as appropriate.
4 Trades executed on the Nasdaq market usually
involve securities firms, which act as market
makers for particular securities, buying from or
selling shares to an investor.  Thus, 100 shares
being sold by one investor and bought by another
results in Nasdaq eventually reporting 200 shares
as having traded.  This occurs because the market
maker reports an executed trade when it buys the
shares from the first investor and also reports a
trade when it sells the shares to the second
investor.  In contrast, executed trades on the
exchanges generally result from the direct
matching of investors' orders to buy or sell. As a
result, the Nasdaq market's trading volume
statistics may appear higher than those of the
exchange markets.  Regardless, the information
systems of the Nasdaq market are required to
process the message traffic resulting from the
transactions between investors and its market
making firms.
5 SEC's Order Handling Rules required Nasdaq
market makers to display customer limit orders and
to disseminate the best prices for orders placed
by market makers in the trading systems operated
by ECNs.
6 Day trading is a strategy that generally
involves making multiple purchases and sales of
the same security during the day to profit from
short-term price movements.  See Securities
Operations:  Day Trading Requires Continued
Oversight (GAO/GGD-00-61, Feb. 24, 2000).
7 As a result of a January 2000 SEC report on
Nasdaq's information systems, SEC recommended that
NASD hire an external contractor to review NASD's
infrastructure capacity and its capacity planning
process.   In response, NASD contracted with
SRI/Atomic Tangerine to conduct this review.
8 Stocks traded on the Bulletin Board are usually
small companies with insufficient revenue or
assets to be listed on the Nasdaq's primary
market.
9 Securities listed by one exchange are also
usually traded on other exchanges or markets.  For
example, many stocks listed on NYSE are also
listed and traded by the other regional exchanges,
such as the Pacific Exchange or the Chicago Stock
Exchange.  In addition, some members of the Nasdaq
market also make markets in exchange-listed
securities.  This trading of exchanged-listed
securities on Nasdaq is commonly referred to as
the "Third Market."
10 Assessing the Impact on Message Traffic of
Trading Equities and Options in Decimal
Increments, SRI Consulting (Arlington, VA: Apr. 6,
1999).
11 On Decimals 2000 - Will the Exchanges Convert?,
Statement of Richard A. Grasso, Chairman and Chief
Executive Officer.  Before the Subcommittee on
Finance and Hazardous Materials, Committee on
Commerce, U.S. House of Representatives (June 13,
2000).
12 Stock Market Automation:  Exchanges Have
Increased Systems' Capacities Since the 1987
Market Crash (GAO/IMTEC-91-37, May 10, 1991).
13 Application and Order Pursuant to Section 11A
(a)(3)(B),  Exchange Act Release Rel. No. 34-
41843, 64 Fed. Reg. 50126 (Sept. 8, 1999).  The
order specifically applied to the American Stock
Exchange, LLC; the Chicago Board Options Exchange,
Inc.; NYSE; the Options Price Reporting Authority;
the Pacific Exchange, Inc.; the Philadelphia Stock
Exchange, Inc.; and the Securities Industry
Automation Corporation.
14  Order Directing the Exchanges and National
Association of Securities Dealers, Inc., To Submit
a Decimalization Implementation Plan Pursuant to
Section 11A(a)(3)(B), Exchange Act Release No. 34-
42360, 65 Fed. Reg. 5004 (Jan. 28, 2000) and Order
Directing the Exchanges and the National
Association of Securities Dealers, Inc. To Submit
a Phase-In Plan to Implement Decimal Pricing in
Equity Securities and Options Pursuant to Section
11A(a)(3)(B), of the Securities Exchange Act of
1934, Release No. 34-42914, 65 Fed. Reg. 5004
(June 8, 2000).
15 We discussed the results of this SEC report in
the previous section relating to NASD.
16 Order Directing the Exchanges and NASD to Submit
a Phase-In Plan to Implement Decimal Pricing in
Equity Securities and Options Pursuant to Section
11A(a)(3)(B), Exchange Act Release No. 34-42914
(June 8, 2000).
17 Named as "Participants" in the order were the
American Stock Exchange, LLC; Boston Stock
Exchange, Inc.; Chicago Board Options Exchange
Inc.; Chicago Stock Exchange, Inc.; Cincinnati
Stock Exchange, Inc.; International Securities
Exchange, LLC; National Association of Securities
Dealers, Inc.; NYSE; Pacific Exchange, Inc.; and
Philadelphia Stock Exchange, Inc.
18 GAO/T-GGD-00-96.
19 Proposed Rule: Options Price Reporting
Authority; Proposed Amendments to National Market
System Plan. Release No. 34-42755; File 4-434 (May
4, 2000).
20 Arbitrage is the practice of buying securities
in one market and simultaneously selling them in
another market to take advantage of a difference
in price quotations between the two markets.
21 For additional information, see On-Line Trading:
Better Investor Protection Information Needed on
Brokers' Web Sites (GAO/GGD-00-43, May 9, 2000).
22 Government Auditing Standards, United States
General Accounting Office, June 1994.

Appendix I
Comments From the Securities and Exchange
Commission
Page 42  GAO/GGD/AIMD-00-319 Decimal-Trading Delay

Appendix II
Comments From the Nasdaq Stock Market, Inc.
Page 45  GAO/GGD/AIMD-00-319 Decimal-Trading Delay

Appendix III
GAO Contacts and Staff Acknowledgments
Page 46  GAO/GGD/AIMD-00-319 Decimal-Trading Delay
GAO Contacts
Thomas J. McCool, (202) 512-8676
Cody J. Goebel, (202) 512-7329

Acknowledgments
     In addition to those named above, Davi
D'Agostino, Daniel Goldstein, Edwin Lane, and Jean-
Paul Reveyoso made key contributions to the
report.

Related GAO Products
Page 48  GAO/GGD/AIMD-00-319 Decimal-Trading Delay
On-Line Trading: Better Investor Protection
Information Needed on Brokers' Web Sites (GGD-00-
43, May 9, 2000).

Securities Pricing: Progress and Challenges in
Converting to Decimals (T-GGD-00-96, Mar. 1,
2000).

Securities Operations: Day Trading Requires
Continued Oversight (GGD-00-61, Feb. 24, 2000).

Year 2000: Financial Institutions and Regulatory
Efforts to Address International Risks (GGD-99-62,
Apr. 27, 1999).

Securities Market Operations: The Effects of SOES
on the Nasdaq Market (GAO/GGD-98-194, Aug. 1998).

Securities Pricing: Actions Needed for Conversion
to Decimals (T-GGD-98-121, May 8, 1998).

SEC Year 2000 Report: Future Reports Could Provide
More Detailed Information (GGD-98-51, Mar. 6,
1998).

Stock Market Automation:  Exchanges Have Increased
Systems' Capacities Since the 1987 Market Crash
(GAO/IMTEC-91-37, May 10, 1991).

Financial Markets: Active Oversight of Market
Automation by SEC and CFTC Needed (GAO/IMTEC-91-
21, Apr. 2, 1991).

*** End of Document ***