It was an article of faith: Change stock prices from those awkward sixteenths of a dollar into pennies, and investors would score. Trimming the smallest difference in most prices from 6.25 cents to a single cent would cut trading costs and investors would save billions. And so, under pressure from Congress, the New York Stock Exchange began rolling out decimal trading last August, with the Nasdaq to follow this spring.
Well, saving big bucks was the idea, anyhow. Evidence is now emerging that the switch could end up costing many investors more, not less. It's clearly too late to halt the march to penny pricing. But the early results mean Wall Street and the Securities & Exchange Commission should further retool the markets to guarantee that investors--and not market insiders--get the promised payoff of "decimalization."
LINE JUMPERS. Decimals are hailed as an investor bonanza because smaller price increments allow stocks to trade with a narrower "spread," or gap between buying and selling prices. The spread is essentially the house's cut of trading activity--and a major cost for investors. With sixteenths as the smallest increment, the best price a seller can get may be 20, while the lowest price for buyers may be 20 1/16--meaning the spread is 6.25 cents per share. But with stocks trading in pennies, the best prices might be 20 and 20.04, cutting the spread to 4 cents.
Savings may be there--for small orders placed by individual investors. But for institutional investors, such as pension and mutual funds, penny pricing may boost costs instead. And that stands to hurt the many individuals for whom these funds invest.
Institutions may pay more because decimal trading tends to discourage them from placing "limit orders"--bids to buy or sell at specified prices. Limit orders are popular because they can protect against price movements between the time an order is placed and when it's executed. Limit orders also help buyers and sellers meet in an orderly fashion, and act to keep prices from bouncing wildly.
In a study of 63 stocks that converted to decimal trading beginning last August, the NYSE has found that the share of trading done through limit orders has fallen by about 10%. Some experts blame the trend on the decimal-induced growth of "stepping ahead"--the market equivalent of someone cutting ahead of you in line.
It works like this: When a stock is selling at 29 15/16, you might place a limit order to buy at 30. A broker or dealer, seeing that order, can jump ahead by bidding 30 1/16--and thus snatch up the shares you wanted. With penny trading, the cost of beating your order falls sharply, because the insider only needs to bid 30.01. The practice isn't illegal, but how do investors respond? They place fewer limit orders, researchers say.
The shrinkage can make trading costlier, as it becomes more arduous for buyer and seller to meet. A study by Babson College and University of Pennsylvania researchers showed the volume of stock offered through limit orders fell by one-half when the Big Board moved from eighths to sixteenths in 1997. And a soon-to-be-published study by Columbia University and University of Georgia scholars notes that institutions' trading costs soared by as much as one-half in the same switch.
Already, decimals are forcing institutions to shy away from limit orders, turning to pricey floor brokers instead. These are middlemen who handle trades on the NYSE floor, bypassing the electronic system that limit orders use. But they charge about 3 cents to 6 cents per share.
RAISING THE STAKES. The easiest way to protect limit orders: Make it more expensive to step ahead. The SEC and exchanges should require a specialist, dealer, or broker who wants to outbid a limit order to offer a significantly better price--say, 3 cents or 5 cents more--and to buy or sell more shares than the limit-order investor wanted. The idea is simple: Make the pros put real money at risk, so they'll think twice before jumping the queue.
Experience may well lead regulators to fine-tune the price and size premiums for line-jumpers. If the penalties are too stiff, price competition could suffer. But striking a balance will give the professionals the maneuvering room they need, while ensuring that small investors get the benefits from penny trading.