Rogue Missives Friday, May 9, 1997

The common sense reform of converting the prices of U.S. stocks from fractions to the otherwise universally applied decimal system has long been championed by Securities and Exchange (SEC) Commissioner Steven Wallman, as well as most large pension funds and money managers. The proposal has now moved a little closer to becoming reality, though, now that Congress is considering the "Common Cents Stock Pricing Act," a bill that would empower the SEC to mandate the change.

The U.S. House bill H.R. 1053 was introduced March 13 by Rep. Michael G. Oxley (R-Ohio), the Chair of the House Commerce Subcommittee on Finance and Hazardous Materials (a curious combination), and has gained support from Rep. Edward J. Markey (D-Massachusetts), the subcommittee's top Democrat. "A modern decimal system," Oxley argued at the time, "is better for small investors and better for our national competitiveness."

During recent hearings on the proposal, some representatives, including Democrat Thomas Manton and Republican Rick Lazio, both of New York, expressed reservations about the bill and suggested that further study was needed, to determine whether Congress and the SEC ought to intervene and to make sure such a change would not disrupt the markets.

But Commissioner Wallman, the strongest voice for progressive changes at the SEC, told the subcommittee, "While we could continue to study the issue, I doubt we will learn much more than we already know. In the meantime, we know that the studies to date, and the experience of other markets, support moving to decimals as soon as possible." Since the Toronto Stock Exchange adopted decimal pricing early last year, the U.S. has been the only nation whose major markets use fractions.

Though the proposal has not yet made it out of the subcommittee for a vote by the full Commerce committee, the Washington Post reported last week that the "Common Cents" bill has a good chance of passing the House. Investors everywhere should hope that it does and cheer those parties that support it.

By reducing the artificially wide spread between a stock's "bid" and "ask" prices, the measure would lead to more efficient pricing, boosting confidence in the markets and potentially saving investors billions of dollars annually. Barlett Naylor of the Teamsters union, for example, told the subcommittee that the switch to decimals could save the union's pension fund $21 million each year.

That's money that will bypass the market makers who simply handle the trades and go instead to enhance the pensions of union members and boost the incomes of the money managers who actually make the investment decisions. For this very reason, Wall Street's cartel of market makers, the mere handmaidens of American capitalism, continue to resist a change to decimals, revealing an ironic distaste for the kind of free-market price competition that permeates nearly every other corner of American society.

As investors are well aware, U.S. stocks are currently priced in dollars and fractions of dollars. Though the Nasdaq market has recently lowered its pricing increments to 16ths and can in some cases use even smaller fractional figures, the overwhelming majority of shares on that market as well as on the New York Stock Exchange (NYSE) continue to trade in eighths (1/8, 1/4, 3/8, and so on). The practice goes back to the 18th century when, as Rep. Oxley put it, "trading was done under an oak tree" and the currency of choice, the Spanish real, was sliced into eight bits, known as pieces of eight.

This tradition has grown increasingly bizarre in an age when stock transactions occur via a high-speed, high-tech web of digital signals readily able to employ the decimal system on which all world currencies are based. Some old-timers have resisted the change because they're simply more comfortable dealing with fractions, and there's no question that it will take some time for all market participants to get accustomed to decimal pricing. Yet a move to decimals is the best way to improve pricing. It's just less confusing to say a stock is trading for $15.41 instead of $15 13/32.

But the real problem, so to speak, is that the denominations that worked for Blackbeard or your basic colonial highwayman still work pretty well for the modern-day pirates who run the stock markets like a confidence game.

The Nasdaq broker-dealers and NYSE specialists whose job it is to provide liquidity and literally make a market in a security love the 1/8 increments. They're convinced they can make more money under this system than they could under a regime that did not impose this artificial constraint on stock prices. In fact, many of the reforms at Nasdaq over the last year grew out of an academic study and an ensuing Justice Department investigation showing that market makers actively colluded to keep stock spreads at 1/4 by avoiding "odd eighths" pricing (prices ending in 1/8, 3/8, 5/8, or 7/8).

A spread works like this. A Nasdaq market maker is required at all times to broadcast to the market the price at which he's willing to buy a stock (the "bid") and the price at which he's willing the sell it (the "ask"). Even in the most heavily traded stocks, the spread is still typically one-eighth of a dollar. This spread becomes the market maker's profit margin, either 12.5 cents or now in some cases 6.25 cents per share, because he's willing, for example, to buy at the 1/8 bid but sell only at the 1/4 ask price.

Though a NYSE specialist broadcasts only the latest transaction price, that price already reflects the specialist's trading for her own account. So the pricing process is broadly similar, reflecting three related facts. The specialist's job, like the market maker's, is to ensure liquidity and help establish the market price, and the specialist undertakes this task in order to profit from it. Fractional pricing make pricing less efficient while providing the major source of a specialist's profits.

This spread may seem like peanuts, but multiplied by billions of shares changing hands each year, the charge adds up to profit for the Wall Street firms that make markets and lost opportunity for investors who must pay these middlemen what amounts to an unseen commission when buying or selling securities. This hidden cost of trading on the major U.S. markets is even worse for investors who prefer lower-priced stocks.

Let's say you've got about $5,000 to invest. If you buy 100 shares of a stock offered at $50 1/8, you're essentially paying $5,000 for the stock and $12.50 for the spread, since it's likely the market maker has just purchased those 100 shares from someone else for $50 a share. Yet if you buy 500 shares of a stock trading at $10 1/8, you will effectively pay $5,000 for the stock but $62.50 for the spread. Even if the spread drops to 1/16 on the lower-priced stock, the market maker still pockets a disproportionately significant $31.25 from your trade.

The new Nasdaq rules that allow investor limit orders to be broadcast to the overall market have helped narrow spreads by providing outside competition designed, in part, to keep the market makers honest, or at least as honest as the specialists who work the NYSE. Still, pricing by eighths or even sixteenths imposes unnecessary costs on investor transactions by ensuring that the market makers have a nearly guaranteed profit of 6.25 cents or even 12.5 cents per share.

Decimal pricing could allow the use of nickle or even penny increments. The Toronto Exchange, for instance, uses five-cent ticks for stocks trading for $5 or more and penny increments for stocks below $5. According to Junius Peake, a University of Northern Colorado finance professor and a former vice chair of the National Association of Securities Dealers (NASD), an across-the-board change of just one cent per share could save investors $3 billion a year.

According to The Wall Street Journal, Rep. Oxley recently said the bill is necessary because "I don't think the exchanges will move to decimalization without a push from Congress and the SEC." Indeed, the Associated Press reported in late April that Richard Grasso, chair of the NYSE, told a meeting of the Society of American Business Editors and Writers that he expects the big board will eventually make the shift to decimals but that "the market will dictate when that happens."

Clearly, the problem is not just the feared economic hit that NYSE specialists or Nasdaq market makers would feel but a broader issue of power. It makes sense that the bill would find a supporter in Robert M. Greber, chair of the Pacific Exchange, the nation's third largest stock market, which competes most directly with the NYSE. "Any proposal that enhances competition and offers investors better prices ought to be carefully and deliberately pursued," he said in testimony before Congress last month.

The most-repeated excuse offered by the NYSE is that changing to decimals would require an expensive overall of the exchange's computer system that could cost $1 billion or more. But as Wallman told the Journal, the computers that the exchanges and brokers already use to place and record trades actually convert the trades from fractions to decimals and then back to fractions.

Furthermore, the studies Wallman alluded to in his testimony before Congress include three analyses of the Toronto Exchange's recent shift to decimals that suggest that the critics of change in the U.S. are not just hurting investors but may also be hurting themselves.

Jeffrey P. Ricker, an investment strategist and consultant based in San Francisco, studied activity on the Toronto Exchange from January to June of 1996. He found that under decimal pricing, investors saved about a penny per share, as the average spread narrowed by 30%. The largest, most active stocks traded at the minimum spread most of the time, suggesting that using penny increments rather than nickle ticks could have further reduced the spread and increased cost savings for investors.

Jeffrey M. Bacidore, a professor at Indiana University in Bloomington, reached a similar conclusion in his study of trading between February and June of 1996 in stocks listed on the Toronto Exchange but not on a U.S. market and trading for $5 or more. He found the average spread narrowed by almost 20%.

Only somewhat unexpectedly, the market makers in Toronto actually saw their revenues increase after the shift to decimals. In a study conducted by Daniel G. Weaver, an assistant professor of finance at Marquette University, the narrowed spreads led to an increase of orders that more than compensated for the lower per-trade commission.

Despite such findings, there's no doubt that the folks who make their living 12.5 cents-ing America's investors still fear that a change to decimals is just an attempt to fleece them of their institutionally protected right to hefty profits. But their attempts to demonize the proposal sometimes sound absurd.

E.E. Geduld, the president of the giant market maker Herzog Heine Geduld, told the Journal last November, "Communism sounded good too, until it became real."

So said the pot of the kettle. Fractional pricing is ultimately just an archaic practice that amounts to a state-sanctioned means of subsidizing the market makers themselves. And this at a time when there's no reason to believe, for the sake of the market's liquidity or integrity, that these guys need such a subsidy. In a world of increasingly free markets and anti-inflationary price competition, it seems time for America's stock markets to catch up with the trend.

To express your thoughts about the House bill, which has not yet gone to the Commerce committee for a vote, write to Rep. Michael Oxley ([email protected]). For more on the proposal, visit (www.house.gov/oxley/decimal.htm).

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