August 28, 2000 marked the day of the decimal in the US stock market. The phased-in conversion from fractional to decimal pricing began with small groups of New York Stock Exchange-listed stocks Anadarko Petroleum, FedEx, Forest City Enterprises, Gateway, Hughes Supply and MSC Software. The phase-in process will continue until April 2001, by which time the Securities and Exchange Commission (SEC) says all stocks on all US exchanges must be trading in decimal prices.
Like any change, the decimalization of US stock prices has stirred up controversy. Fractional prices served our markets well for over 200 years, causing some market participants to wonder about the need for fixing something that was not broken. Many have argued, however, that fractions were archaic: their genesis dates back to the early days of the American government when the Spanish thaler (pronounced “dollar”), a pizza-shaped coin that could be broken into eighths, was the most reliable currency for trade. Nor could anyone who is not a professional stock trader claim that fractions were easy to translate into cents.
“Decimal pricing will remove the extra step of figuring out the value of complicated fractions such as 243/256,” notes Leonard Griehs, vice president of investor relations at Campbell Soup Co. In addition to simplifying calculations and record keeping, decimalization will also bring US markets into sync with the rest of the world’s capital markets, which all currently trade in decimals.
Congress and the SEC have propelled the move to decimalization with the laudable goals of making the markets more comprehensible to the average person and leaving more money in investors’ pockets. But that hasn’t stopped some market watchers and participants from voicing concern that decimalization may profoundly change the way the market functions and lead to consequences that run counter to investors’ interests.
More ticks & trades
With stocks traded in sixteenths, there are 16 possible “ticks” or changes from one dollar of price to the next; decimalization increases the number of ticks to 100. In theory, this should shrink the space between prices as well as the “spread”, or difference between the buyer’s bid and the seller’s ask. In some trades, narrower spreads will benefit investors by decreasing the source of potential profit for the market maker who may be on the other side of the transaction. However, this perceived benefit is a moot point for the 85 percent of trades currently executed on the NYSE where buyers and sellers are matched directly in a zero-sum relationship. Furthermore, what market makers stand to lose on spreads will be recouped thanks to an increase in trades and transaction commissions. With sixteenths, a better price requires a commitment or sacrifice of at least 6.25 cents per share. By lowering the stakes to as little as a penny, decimalization should prompt more trading activity. “When the trading increment changed from eighths to sixteenths as the first step toward decimalization in 1997, volume really jumped,” recalls Mark Vachon, director of corporate investor communications for General Electric. The Securities Industry Association (SIA) forecasts an 81 percent surge in equity transactions and a 276 percent increase in option messages as a result of decimalization. Given the strain such a surge could place on the system, the securities industry is investing an estimated $907 mn to expand capacity and accommodate the change, according to the recent SIA study.
Behavioral impacts
Impact on market behavior will determine whether the faster pace of trading is beneficial. “By increasing the speed and volume of order messages, decimalization will challenge the ability of stock market technology to deliver a clear picture of current price quotes,” says Robert Schwartz, professor of economics and finance at City University of New York’s Baruch College. “As orders are spread out over a wider range of prices, the information content of the displayed bids and asks from the “top of the book” may be obfuscated. Option quote screens could become a blur.” Investors’ reaction to this challenge remains to be seen.
A faster trading pace could also trigger the kind of momentum-driven price movements that tend to overlook fundamentals and confound senior management. As prices change more quickly, they may also appear to be more volatile; moves from $32.46 to $32.71 to $32.65 could sound a bit more dramatic than “up a quarter” or “down a sixteenth.”
Decimalization is likely to have the biggest impact on institutional investors – namely mutual funds and pension funds – who today provide the stock market with most of its liquidity. Liquidity results not only from actual transactions, but also from institutions’ use of limit orders that indicate the price at which they are willing to trade. The public display of limit orders provides the market with important indications of investor sentiment.
Decimalization might make institutional investors more reluctant to reveal their intentions through limit orders, because they won’t want to risk the possibility that a professional trader will step in and bid a penny more or ask a penny less, thereby penny-ing fund managers out of their trades in the name of price improvement. “If institutions move from limit orders to market orders, they will become demanders of liquidity rather than suppliers,” says Schwartz, “and that won’t be good for the market. Investors will naturally demand higher returns to compensate for liquidity risk, and as higher returns typically result from a lower starting point, prices could decline in the near term.”
In addition, institutions will likely find it more difficult to execute large block trades at a consistent price and will therefore have to break them up into smaller pieces. A fund manager’s ability to get the best price for a trade ultimately affects the individual shareholders and employees these funds exist to serve.
Caution warranted
These possible drawbacks, while serious, can be mitigated by a thoughtful and orderly conversion. “We have to hope for sensible regulatory oversight in the wake of decimalization,” says Griehs. The SEC is prepared to provide just that. It is working closely with the industry to ensure a smooth conversion and is responding to expressed concerns with an extension of the original deadline and the approval for a phased-in approach. As SEC chairman Arthur Levitt testified to Congress in June, “A phase-in period should give the industry time to finalize testing, adjust their systems to correct errors as they phase in particular stocks in decimals, educate investors, and monitor changes in trading behavior. In particular, trading in decimals, especially in penny increments, may affect the use and display of customer limit orders, the liquidity of certain stocks, and the ability to sell short. A phase-in period, even a short one, will allow the commission and the markets to monitor the impact on trading behavior and to see if trading rules need to be adjusted.”
For investor relations professionals, decimalization will require adaptation to a new way of presenting and discussing their company’s stock price. Any effect beyond the cosmetic will depend on the general market reaction and a stock’s individual trading pattern. If the hypothetical liquidity risk becomes real, the impact will be greater on smaller, more thinly traded stocks. For NYSE-listed companies, their specialists can be valuable sources of education and information on decimalization and its outcomes.
In recent years, the US stock markets have risen to the challenge of significant changes such as T+3 settlement, the advent of the euro, and Y2K. In each case, the anticipation of the event proved more stressful than the event itself. Will the decimalization of stock prices follow the same pattern? Only time will tell.
Myles Gillespie is president of Fleet Specialist, a NYSE specialist firm. A member of Fleet’s board of directors and management committee, he manages the firm’s floor operations.
