Securities Pricing: Progress and Challenges in Converting to Decimals
(Testimony, 03/01/2000, GAO/T-GGD-00-96).

Although the securities markets have made progress in preparing for
decimal trading, some key challenges must still be overcome if decimal
trading is to be implemented successfully. The capacity study
commissioned by the Securities Industry Association projected that
decimal trading is likely to significantly increase trade and quotation
message traffic, so a primary challenge will be to ensure that the
industry's communications and processing systems have enough capacity.
The options markets and the Nasdaq face the greatest difficulty in
preparing for the increased message traffic arising from decimal
trading. Other steps that must be taken in preparation for decimal
trading include developing market standards and implementation
procedures, ensuring that market participants' systems are ready to
process decimal prices, and revising all the rules that govern trading.
These steps are still incomplete, however, and, in some cases, progress
has been hampered by other issues, including an ongoing antitrust
investigation of the options markets.

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

 REPORTNUM:  T-GGD-00-96
     TITLE:  Securities Pricing: Progress and Challenges in Converting
	     to Decimals
      DATE:  03/01/2000
   SUBJECT:  Securities
	     Proposed legislation
	     Information resources management
	     Securities regulation
	     Computer software verification and validation
	     Stock exchanges
	     Strategic information systems planning
	     Prices and pricing
	     Systems conversions

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GAO/T-GGD-00-96

United States General Accounting Office
GAO

Testimony

Before the Subcommittee on Finance and Hazardous
Materials, House Committee on Commerce

For Release on Delivery
Expected at
10:00 a.m. EST
on Wednesday
March 1, 2000
GAO/T-GGD-00-96

SECURITIES PRICING
Progress and Challenges in Converting to

Decimals

Statement of Davi M. D'Agostino
Financial Institutions and Markets Issues
General Government Division

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Statement
Securities Pricing:  Progress and Challenges in
Converting to Decimals
Page 6                            GAO/T-GGD-00-96
Mr. Chairman and Members of the Subcommittee:

We  are pleased to be here today to present the
results of our assessment of the securities
industry's progress toward implementing decimal
trading as part of the monitoring we are doing at
your request. In 1998, we testified before this
Subcommittee about actions needed for the industry
to convert from fractions to decimals.1  At that
time, we noted that the industry should complete
its work in preparing for the 2000 date change
before attempting to implement decimal trading.
However, we also recommended that the Chairman,
Securities and Exchange Commission (SEC), take
various steps to ensure that timely implementation
of decimal trading would occur thereafter.  These
steps included ensuring that the industry
established definitive implementation time frames
and assessed the impact of decimal trading on the
securities industry's information processing and
communication system capacities.

Today, I will focus my remarks on two key areas:
the progress made to date toward converting to
decimals and the challenges that remain.  In
response to our recommendations, SEC and the
industry have taken actions to help ensure that
the securities markets implement decimal pricing
in 2000.  SEC staff have been monitoring the
securities industry efforts, which are being
coordinated by the Securities Industry Association
(SIA), to develop time frames and standards for
implementing decimal pricing and have issued two
orders directing industry participants to work
jointly on these tasks.  In addition, SIA
commissioned a study of decimal trading's impact
on trading and price quotation volumes.

Although securities market participants have made
progress in preparing for decimal trading, some
key challenges remain for the industry to
successfully implement decimal trading. Because
the capacity study commissioned by SIA projected
that decimal trading is likely to significantly
increase trade and quotation message traffic, a
primary challenge will be to ensure that the
industry's communication and processing systems
have adequate capacity.  The options markets and
the Nasdaq Stock Market, Inc. (Nasdaq) face the
greatest difficulty in preparing for the increased
message traffic from decimal trading.  Other steps
that must be completed before decimal trading can
be implemented include developing market standards
and implementation procedures, ensuring that
market participants' systems are ready to process
decimal prices, and revising all rules necessary
to govern trading.  However, these steps are not
yet complete and, in some cases, progress has been
hampered by other impediments, including an
ongoing antitrust investigation of the options
markets.

This statement is based on our monitoring efforts
to date.  To monitor SEC and securities industry
efforts to implement decimal trading, we observed
the industry meetings being coordinated by SIA and
interviewed SEC officials.  Regarding the
industry's efforts to assess decimal trading's
impact on its system capacities, information
technology and research methodology experts among
our staff evaluated the private consulting firm's
study.  We interviewed officials from the
consulting firm that prepared the capacity study,
as well as representatives from the equities and
options markets to discuss capacity issues.  We
also obtained and analyzed information from the
Securities Industry Automation Corporation (SIAC)
and the Options Price Reporting Authority (OPRA),
which are the entities that administer the systems
used to disseminate trade and price quotation
messages for the stock and options markets.

Progress Made Toward Implementing Decimal Trading
As recommended in our 1998 testimony, SEC and the
securities industry have taken various steps to
help ensure that the securities markets transition
to decimal trading in 2000.  SEC staff have
conducted periodic meetings with industry
participants about decimal issues and have
monitored the efforts of SIA committees working to
implement various aspects of decimal trading.  SEC
staff also cooperated with the private consulting
firm that prepared the study of decimal trading's
impact on industry systems capacity and held
discussions with this firm and other market
participants on the study's results.

For its part, the securities industry, under the
auspices of SIA, has been meeting to coordinate
plans and standards for implementing decimals.  In
addition, the various U.S. exchanges, Nasdaq, and
other securities organizations have also scheduled
three industrywide tests of decimal trading in
April, May, and June 2000.

In January 2000, SEC took a significant step
towards the implementation of decimal trading.  On
January 28, 2000, SEC issued an order2 requiring
certain market participants, including the stock
and options exchanges, and National Association of
Securities Dealers, Inc. (NASD),3 to work together
to prepare a plan that would ensure that decimal
trading would begin by July 3, 2000.
Specifically, the order directed these market
participants to develop and submit a plan to
implement decimal trading to SEC by March 13,
2000.4

The market participants subject to the order have
not yet formally submitted their implementation
plan to SEC and the details are subject to change.
However, the industry members, working under the
auspices of SIA, developed a draft schedule for
implementing decimal trading using a phased
approach.  According to that draft plan, the
industry intends to begin the first phase of
implementation in July 2000, as reflected in the
SEC order.  As shown in figure 1, under the draft
plan, during the first month, the prices of a
small number of stocks (about 30) would be quoted
in decimals with a minimum price variation (MPV)
no greater than a nickel.  A second phase would
then begin in which all stocks would be quoted
with an MPV of no more than a nickel.  During the
second phase under that draft plan, a pilot would
also be conducted in which a selected number of
stocks would be quoted in penny increments.  After
January 2001, the final phase of the
implementation would begin in which the individual
markets would file rule changes with SEC seeking
approval of the MPVs with which they intend to
quote prices.

Figure  1:  Industry Draft Implementation Phases
for Decimal Trading (as of February 25, 2000)

Adequate Systems Capacity Is the Primary Challenge
to Decimal Trading
As we noted in our 1998 testimony, successful
implementation of decimal trading in the United
States would require regulators and the industry
to ensure that adequate capacity exists to
accommodate the expected trade and price quote
message traffic that would have to be processed
and communicated industrywide.   The SIA-
commissioned study of the impact of decimal
trading on processing and communication capacities
was performed by a private consulting firm, SRI
Consulting.  The SRI study concluded that
substantial increases in message traffic in both
the equities and options markets would likely
occur.

At our request, SRI provided us with its most
recent projections for peak message traffic
volumes arising from decimal trading.  These
projections include not only the impact of decimal
trading, but also of other developments in the
markets that are increasing message traffic, such
as record trading volumes and increased
competition among options exchanges. SRI has
developed projected peak message traffic volumes
for exchange-traded securities, Nasdaq securities,
and for equity and index options.  For each type
of security, SRI has estimated what the message
traffic volumes will be by December 2001 for three
scenarios:  (1) without decimal trading, (2) with
decimal trading with a nickel MPV, and (3) with
decimal trading with a penny MPV.

As shown in figure 2 below, SRI estimates that
peak message traffic for securities traded on the
exchanges would be 50 percent higher by the end of
2001 from its December 1998 levels without any
impact from decimal trading.  However, if these
securities trade in decimals with a penny MPV,
peak message traffic could increase by as much as
256 percent from December 1998 to December 2001.

Figure  2:  SRI Projections for Exchange-Traded
Securities' Peak Message Traffic From December
1998 to December 2001 (Data as of February 24,
2000)

As shown in figure 3 below, SRI estimates that
peak message traffic for securities traded on
Nasdaq will be 174 percent higher by the end of
2001 from its December 1998 levels without any
impact from decimal trading.  However, if Nasdaq
securities trade in decimals with a penny MPV, SRI
projects that peak message traffic for securities
traded on Nasdaq could increase by 700 percent by
December 2001.

Figure 3:  SRI Projections for Nasdaq Securities'
Peak Message Traffic From December 1998 to
December 2001 (Data as of February 24, 2000)

As shown in figure 4 below, SRI estimates that
peak message traffic for equity and index options
will be 779 percent higher by the end of 2001 from
its December 1998 levels without any impact from
decimal trading.  However, if these options trade
in decimals with a penny MPV, SRI projects that
their peak message traffic could increase by 3,033
percent by December 2001.

Figure 4:  SRI Projections for Options' Peak
Message Traffic From December 1998 to December
2001 (Data as of February 24, 2000)

As you requested, we evaluated this study and
found that it generally used reasonable
methodologies to produce its findings.  The
study's projections for securities trading with a
nickel MPV and for options traffic were produced
using historical data and projection models
similar to those already used in the industry.
However, the traffic estimates for decimal trading
in securities with penny MPVs may have been
subject to greater error because they relied on
the opinions of market participants as the primary
input to the models used for these projections.
However, neither SRI nor we could identify other
reasonable sources of such information.  SEC
officials noted during the time that the market
participants provided input to the SRI study,
trading volumes in securities markets were rapidly
increasing and this would have made estimating
future volumes even more difficult.  Nevertheless,
they said that these participants would have been
the best sources for such estimates.  For example,
an SRI official told us that historical data could
not be used to estimate trading behavior for penny
MPVs because securities on U.S. or foreign markets
do not generally trade in such increments.

Recognizing the potential impact of decimal
trading on the industry's system capacities, as
previously discussed, the second phase of the
industry's implementation plan is expected to
include a pilot program, in which selected
securities would be quoted with penny MPVs. Such a
pilot should help the market participants and SEC
to evaluate the potential effects of smaller
trading increments on capacity and trading
behavior.5

Options Exchanges Are Most Challenged in
Addressing Likely Message Traffic Increases
Based on the SRI projections, the transition to
decimal trading in U.S. securities markets could
have the greatest impact on message traffic
volumes for options.  The OPRA system is used to
disseminate trade and price quote messages for
equity and index options industrywide.  OPRA
officials told us that upgrading their systems to
handle the increase in options traffic expected
from decimal trading is a major challenge.  One
OPRA official said that increasing the system's
capacity to handle the projected decimal trading
volumes would "require enough telephone lines to
support a small city."  Furthermore, OPRA
representatives noted that some of the message
traffic projections for options are so high that
traders would have difficulty interpreting and
acting on such rapidly changing information.

To be able to process the current and projected
message traffic volumes, OPRA intends to begin
increasing the capacity of the system. According
to OPRA officials, they expect to increase the
OPRA system's processing capacity during 2000 from
its current maximum of 3,000 messages per second
to 12,000 messages per second by December 2000.

However, this additional capacity will not be
adequate to accommodate the SRI projections. OPRA
has begun taking several steps to reduce quotation
traffic because the current message volumes are
already approaching industry capacity limits.  For
example, each of the options exchanges has agreed
to internally prioritize its own quote and trade
report message volume so that the amount of
traffic submitted to OPRA does not exceed
specified percentage allocation of the OPRA
system's total capacity.

The participants in the OPRA systems have also
been working with SRI to prepare additional
strategies to further reduce this system's message
traffic.  For example, they are considering
discontinuing price quotes for options with low
trading volumes.  In addition, they have discussed
establishing MPVs for options quotations of 5
cents or a 10 cents as another way of limiting
message traffic after decimal trading begins.
According to an SIA official, such steps are
necessary to reduce the expected message volume to
levels below the maximum capacity of the options
systems.  Because of potential market impacts, SEC
plans to review the mitigation strategies proposed
by the exchanges and must approve any resulting
changes to exchange rules, including any
restrictions on the level of options quotation
MPVs.

Decimal Trading Also Poses Capacity Challenges For
the Nasdaq Market
As the SRI study indicated, trading in decimals
will also increase message traffic for the
equities markets, but to a lesser degree than for
the options markets. According to SIA officials,
the exchanges offering listed securities likely
have adequate capacity to absorb the likely
increase in quotation message traffic expected to
result from decimal trading. However, as shown
previously, SRI's latest projections indicated
that trading in penny MPVs may increase Nasdaq
quotation message traffic by 700 percent between
December 1998 and December 2001.

According to Nasdaq officials, their market is
already experiencing processing strains because of
unprecedented increases in trading volumes.  For
example, they provided us with data that indicated
that their average daily share volume since the
beginning of 2000 is almost 1.7 billion shares,
which represents a 61 percent increase over their
average daily volume in 1999.

Because of their need to expand their ability to
process these volumes, Nasdaq officials have
informed SEC that their market would not be ready
until the first quarter of 2001 to accommodate
their own lower estimates of the increased message
traffic expected from decimal trading with penny
increments.  Nasdaq has not factored into its
planning the increased estimates from SRI.  In
addition, Nasdaq will not be able to participate
in the first two industrywide decimal trading
tests scheduled for April and May 2000, but
intends to participate in the June test.

Decimal Implementation Progress Has Been Slowed in
Other Areas
In addition to addressing capacity issues, the
timely implementation of trading with decimal
prices in U.S. securities markets will also
require other efforts to be completed in a
coordinated manner across the securities industry.
These include finalizing standards for market
operations and practices; revising exchange and
market regulations; and readying the systems of
the exchanges, broker-dealers, and other market
participants for decimal prices. Cooperation among
market participants in a key area has been
hampered in part by antitrust concerns.  However,
the SEC order issued in January 2000 may help
address many of these concerns that have slowed
industry progress by clearly stating that such
cooperation is in the public interest.

Development of Market Standards Has Been Delayed
by Antitrust Concerns
For the conversion to decimal trading to be
successful, various standards, practices, and
implementation procedures have to be agreed to by
the exchanges, markets, and other market
participants. An example of the types of issues
requiring agreement among the participants is the
methodology for converting prices in pending
orders that have yet to be executed when the
markets transition from fractional to decimal
prices. Another issue involves determining how
orders will be routed and processed by the markets
if different exchanges establish different MPVs.

However, we observed and officials confirmed that
progress among the various SIA committees and
subcommittees working on these decimals-related
issues has been slowed by antitrust concerns.
Currently, the U.S. Department of Justice is
conducting an investigation of antitrust issues in
the options markets and various private entities
have filed lawsuits alleging anticompetitive
behavior by the options markets.  Market
participants told us that, as a result, joint
discussions of decimal trading issues could be
viewed as having anticompetitive implications.
Because of these concerns, some SIA committee
meetings on decimal issues were postponed or were
not attended by all relevant officials.  SIA
officials acknowledged that these antitrust
concerns have slowed the various decimal
committees' work to complete the necessary
standards and implementation procedures.

SEC and others have attempted to mitigate the
effect of antitrust concerns on the progress of
the decimal trading implementation. On September
8, 1999, SEC issued an order that directed certain
stock and options exchanges, SIAC, and OPRA to
work cooperatively on options quote message
traffic issues expected to arise as a result of
decimals-related issues.6 The SEC order noted that
such cooperation was unlikely to have adverse
impacts on competition and would be in the public
interest. In a letter dated September 23, 1999,
the Department of Justice approved the SIA's
proposed plan for exchanging information among
market participants relating to decimal
implementation. SIA's plan outlined specifically
how information would be aggregated and disclosed
and set limitations on the type of information
that would be shared among participants. According
to the business review letter, as long as the
information exchanges were of the nature SIA
proposed and were conducted according to the
practices it outlined, the Department would not
consider such activities to be anticompetitive.

Despite these actions, cooperation among the
industry participants working on the decimal
implementation continued to be hampered by
antitrust concerns. For example, at a December
1999, SIA steering committee meeting held after
the release of SEC's order and the Department of
Justice letter, certain industry participants left
the meeting when the discussion turned to how MPVs
would be processed because of their continuing
concerns over the antitrust implications.
According to SIA officials, other delays continued
to occur because of these concerns.

SEC expects that its January 2000 order will
remove any further unwillingness among industry
participants to work together on decimal
implementation arising from the antitrust
concerns.  The order cites SEC's authority under
the Securities Exchange Act of 1934 to require
joint activity by the self-regulatory
organizations that could otherwise be asserted to
have an impact on competition where such activity
serves the public interest and the interests of
investors.  The order states that decimal pricing
could benefit investors and increase market
efficiency and fair competition.  Because
information in the securities markets is processed
and shared among various entities, the SEC order
indicates that "it is imperative that all market
participants convert to decimals in a coordinated
manner."  The order states, therefore, that having
these participants work jointly in discussing,
developing, and implementing decimal trading
furthers the public interest.

Exchange and Market Rules Also Have to Be Revised
The conversion from trading in fractional to
trading in decimal prices will also require
changes to various self-regulatory organization's
rules, but the industry has not yet completed or
submitted to SEC a full set of proposed rule
changes.  For example, SEC officials said that
rules that refer to fractional increments would
have to be revised to reflect comparable decimal
increments.  In summer of 1999, SEC staff asked
the exchanges and NASD to submit listings of the
rules they anticipated would need revision as the
result of implementing decimals.  According to SEC
officials, they received lists of rules that
primarily addressed technical and administrative
changes.  However, they told us that changes to
other types of rules may be required as a result
of decimal trading.  For example, some officials
have indicated that the rules regarding short
selling,7 which require that such trades be
executed only after an upward movement in the
security's price, may have to change if decimal
trading results in very low MPVs, such as pennies.
With smaller MPVs, market officials said that
manipulating the market to ensure that a higher
priced trade occurs before selling short would be
less costly and possibly easier to accomplish.
However, not all of the markets' initial
submissions to SEC addressed these types of rules.
A New York Stock Exchange official told us that
his exchange wanted to wait to see exactly how
decimal pricing affected trading before they
propose changes to rules that govern trading
practices.

In the fall of 1999, SEC again asked the exchanges
and NASD to submit final proposed rule changes by
January 3, 2000.  However, as of January 28, 2000,
SEC had not yet received all such proposals in
final form.

Exchanges and Other Market Participants Must Ready
Their Systems for Decimal Securities Prices
In addition to the industrywide efforts, each
individual market participant, including the
exchanges, broker-dealers, information vendors,
and others, must also make changes to their
processing and communication systems to
accommodate decimal prices. As of July 1999, an
SIA survey of firm readiness indicated that little
progress had been made because firms were focusing
on ensuring that their systems would correctly
process date information in 2000. Now that most of
that work has been completed, we would expect that
market participants could turn their attention to
readying their systems for decimals. According to
a SEC official, SEC has begun conducting
examinations to assess firm readiness and will be
coordinating with the examination staff of the
various exchanges and NASD to ensure that similar
reviews are conducted of other market
participants.

GAO Efforts Going Forward
As part of the continuing effort to monitor the
industry's progress toward implementing decimal
trading that you have asked us to perform, we
intend to conduct various activities over the
coming months.   We plan to continue monitoring
SEC's and the industry's progress in preparing for
decimal trading in various areas, including

ï¿½    The approval process for market rule changes,
ï¿½    The assessments made by regulators of broker-
dealers' efforts to ready their systems for
decimals, and
ï¿½    The results of testing among exchanges and
member firms.
In addition, we will continue to participate as
observers on the industry committees currently
preparing market standards and implementation
procedures.

Mr. Chairman, Members of the Subcommittee, this
concludes my prepared remarks.  We would be happy
to answer any questions you have at this time.

Contact and Acknowledgements

For further information regarding this testimony,
please contact Davi M. D'Agostino at (202) 512-
5431.  Individuals making key contributions to
this testimony included Cody J. Goebel, Michael A.
Burnett, Jean-Paul Reveyoso, Carl M. Ramirez,
Sindy R. Udell, and Katherine M. Raheb.

_______________________________
1Securities Pricing: Actions Needed for Conversion
to Decimals (GAO/T-GGD-98-121, May 8, 1998).
2 Order Directing the Exchanges and the 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. 5003 (Jan. 28, 2000).
3 Named as "Participants" in the order were the
American Stock Exchange, LLC; theBoston Stock
Exchange, Inc.; the Chicago Board Options
Exchange, Inc.; the Chicago Stock Exchange, Inc.;
the Cincinnati Stock Exchange, Inc.; NASD; the New
York Stock Exchange, Inc.; the Pacific Exchange,
Inc.; and the Philadelphia Stock Exchange,  Inc.
4 The order also directs the exchanges and NASD
(the Participants) to discuss the implementation
of  decimal trading with certain interested market
participants (the "Interested Parties").  These
Interested Parties include the International
Securities Exchange, SIA, the National Securities
Clearing Corporation, the Depository Trust
Company, the Options Clearing Corporation, SIAC,
the Intermarket Trading System Operating
Committee, OPRA, the Consolidated Tape
Association, and the Consolidated  Quote Operating
Committee.
5 In its January 28, 2000, order, SEC directs that
such a pilot is to be conducted if the decimals
implementation plan submitted by the market
participants includes a phased-in approach in
which a minimum increment greater than a penny is
used.
6 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.; the Pacific Exchange, Inc.;  the
Philadelphia Stock Exchange, Inc.; the
International Securities Exchange, and OPRA.
7 Short selling occurs when investors borrow
shares of a stock that they do not currently own
from other investors and then sell those shares.
Such investors profit when the stock's price
declines and they are able to repurchase the
shares at a lower price to replace the ones they
borrowed.
*** End of document ***