Why decimal trading in the US is causing such a row
John Wheeler is not a happy institutional trader. A glance at his monitor shows the market has moved away from his offer, again. Wheeler, who heads domestic trading at American Century, explains: 'I just offered a stock for 85 cents. Because [professional traders on the NYSE floor and elsewhere] knew they could buy back stock from me for only a few pennies if need be, they went out and sold for 84 cents, 83 cents, 80 cents and lower. I had the lowest price in the land, but was entirely cut out of the picture.'
Wheeler is experiencing a phenomenon called 'pennying,' something he says has been exacerbated by the arrival of decimalization to US stock markets. In fact, increased order jumping is just one of a cluster of consequences emerging to challenge both market structures and those who use them as a result of the seemingly innocuous move to trading stocks in dollars and cents. For corporates the effects are, for now, subtle and indirect (see box). The implications for other market players, most notably those companies' institutional investors, are, however, more conspicuous.
It's not that Wheeler doesn't think trading US stocks in decimals is perfectly sensible. The rest of the world does it; the US buys and sells everything else in dollars and cents; and in theory it saves investors billions of dollars a year. Those billions were being pocketed by market middlemen who capture a profit from the spread. With 100 price points to the dollar instead of 16, decimalization promised to reduce spreads, theoretically transferring money to investors. For smaller investors trading active stocks, it appears to have done just that. In exchange, however, many big institutions say liquidity and depth have been sacrificed; some spreads have even widened, and decimalization has actually increased trading costs.
So-called 'front running' by traders who risk as little as a penny a share to step ahead of their limit orders is but one vexation. But isn't 'price improvement' a good thing? 'It looks good on the surface,' states Wheeler. 'But price improvement is a marketing gimmick for a process which really compromises all investors' interests. Now, decimalization has merely cut costs for intermediaries who step ahead of institutional order flow. That leaves no incentive to display limit orders on the NYSE.'
Dead in the water
That would be a bad thing. If institutions shy away from limit orders in favor of market orders, they will become liquidity demanders rather than suppliers. Further, price improvement's very legitimacy in a penny world has come into question. 'With two-penny spreads, the whole concept is dead in the water,' according to Frederic Rittereiser, chairman and CEO of Ashton Technology Group, and former president of Instinet.
Several solutions to 'pennying' have been offered. Kevin Connellan, director of equity trading at Chicago-based Northern Trust, wants a move to five- or ten-cent increments. 'You would see more depth and prevent people from [so easily] front-running an order,' says Connellan. 'Now, software programs automatically generate [front-running] orders. It's irritating.' Another suggestion is to make professional traders risk more than a penny to outbid a limit order. For his part, Wheeler's solution involves a matching system with no price improvement.
The NYSE is rolling out a system called Institutional XPress specifically designed to help trade large orders. But Wheeler isn't impressed. He helped draft a letter sent by the Investment Company Institute (ICI) to NYSE chairman Richard Grasso calling for significant changes to XPress. In particular, the ICI wants to ditch the 30-second quote display requirement which it says provides a 'free look' to market participants wanting to step ahead of large orders.
The exchange promises modifications, but Catherine Kinney, group executive vice president, competitive position, at the NYSE says one thing that won't change is its agency auction system. 'Clearly, institutions have made a judgment about the value of price improvement for certain sized orders,' says Kinney. She doubts a switch to nickels is in the cards, but requiring something more than a penny to break up an order isn't being ruled out.
Besides the aggravation of being pennied, fund managers also complain markets are dramatically shallower and quotations less informative. To help compensate, the NYSE is opening up the limit-order book and promoting floor brokers' use of handheld wireless terminals to share more depth of information. Furthermore, it is displaying information about liquidity that exists beyond the best bid and/or offer. The NYSE hopes these 'depth conditions' will help improve market transparency. But not everyone thinks they are adequate. 'Institutional customers don't want 75 executions on a trade,' says Sam Ginzburg, senior managing director of equity trading at Gruntal & Company. 'Costs are obviously higher than when we worked in six-cent increments.'
Off Broadway
Since many of its customers aren't confident the NYSE measures - from 'depth conditions' to Institutional XPress - will be satisfactory, some have predicted institutions will look beyond the Big Board for other market iterations. 'Liquidity is less visible which encourages institutions to look elsewhere,' says Northern Trust's Connellan, pointing to Liquidnet, a new buy-side stock trading system which allows a select group of big asset managers to trade large blocks sans front running. 'But unhappy or not, institutions will still have to go to the NYSE because that's where the market is.'
Ashton Technology's Rittereiser agrees. Demand for his eVWAP alternative trading system affiliated with the Philadelphia Stock Exchange has been piqued by traders looking for a haven from orders being splintered by decimalization. But Rittereiser believes exchanges have 'the real estate' which orders can be driven into. 'To be represented in a penny world, you will have to go to an exchange connected to the NYSE,' says Rittereiser. 'A penny bid on an ECN won't be executed because markets move so fast.'
Kinney says the NYSE's challenge is clear: To do whatever it takes to attract liquidity and ensure its agency auction remains the primary price discovery model for institutional business. 'We must be alert and we have demonstrated we can react quickly,' says Kinney. 'But, it will take time to better understand the experience and evaluate the changes we have made.'
Given evidence that decimalization could end up costing investors more - not less - and that liquidity is threatened by fewer limit orders, the way business gets done at the NYSE may well be adjusted. Market management is in a tricky position with Washington - which originally pressured the exchange to adopt decimalization, partly to curb payment for order flow and internalization.
But the chorus of complaints has become loud enough for the NYSE to bring institutional traders and pension managers into a special committee to attempt to deal with them. 'Something must change,' concludes Gruntal's Ginzburg. 'The format has the potential to work but many issues have yet to be decided.'
Those issues will come to the fore in the fall when the NYSE and Nasdaq report to the SEC on decimalization's initial effects and suggest any new rules. Meanwhile, both markets continue to analyze the issue and Congress is cranking up for a re-assessment of decimalization. So what started in Washington is likely to return there. And the countdown to decimalization's final incarnation may have only just begun.
Corporate effect
US equity markets' conversion to a decimal-based quotation system is likely to have a less than profound impact on public companies. 'For most companies decimalization is invisible,' comments Bob Merritt, senior vice president and CFO of Outback Steakhouse. 'It just not on their radar screens.'
But decimalization does affect market quality and efficiency and thus, indirectly, issuers. Some have argued any liquidity crunch would be most felt by smaller OTC companies. If spreads shrank too much, the argument went, it might not be worth a market maker's time to trade them anymore.
In 1997, with the move from 8ths to 16ths, Nasdaq did see market makers pull back at the low end. This time, decimalization may well point the way to the pink slips for the most illiquid stocks. But few expect any great dislocation. 'Market makers will keep the spreads where they can make money,' notes Brian Borders, president of the Washington-based Association of Publicly Traded Companies. 'Stocks with 60 market makers feel much more pressure to reduce spreads than those with only one or two.'
Overall, Borders predicts a net benefit to companies. 'If decimalization makes markets easier for the average investor to understand and also saves them money, then it boosts confidence in market integrity,' he says. 'That will reduce the overall cost of capital for public companies.' Those are big ifs. For now, however, IR professionals can simply present their companies' stock prices in a new way and keep working on their earnings reports.