FOOL ON THE HILL
An Investment Opinion

Pennies From Heaven

By Bill Mann (TMF Otter)
December 6, 1999

Of the major markets around the globe, there are only a few that trade in fractions, and they all happen to be in the United States.

The New York Stock Exchange and the National Association of Securities Dealers, parent of the Nasdaq market, have recently voted to change their respective markets over to decimals within the next year.

No longer will we have to strain our brains figuring out if 9/32 is more than 3/8. (It isn't.) The decimal system will prove to be a much more user-friendly pricing mechanism for equities because it will be easier to use, simpler to interpret, and cheaper.

The sector that is likely to be most nervous about decimalization is the market makers, the largest of which is Knight-Trimark <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NITE)") else Response.Write("(Nasdaq: NITE)") end if %>. These companies provide the actual matching up of a buyer and seller of a stock, taking a cut in the process. This commission, or "spread," is the difference between what the seller nets and what the buyer pays. Further, market makers provide liquidity for smaller, less-traded companies by purchasing them from a seller even if there is no buyer. In these cases, since the market maker is taking a larger risk by holding a stock, the spread is generally wider.

Currently the minimum spread is 1/16, or $0.0625, per traded share. As such, although smaller increments do occur (1/32, 41/64, etc.), most securities trade in a minimum of sixteenths. But with decimalization we will be able to trade securities in increments of one penny. Two years ago Congress lowered the minimum spread from 1/8 to 1/16, and nearly immediately the spread for higher-volume stocks dropped.

Many analysts believe that the decimalization will further drop the spread downward to as little as one penny. This is good news for brokerages and consumers, but there are several risks involved in changing the system. Many experts predict a surge in trading as the cost of trading drops. One consulting group expects the rise attributable to decimalization to exceed 80% as the number of pricing points increase from 16 to 100 per dollar. This could cause a capacity problem for the stock markets, which are currently upgrading their systems to handle the expected rush.

The expected drop in unit profits for market makers should at least partially be made up in an expected increase of volume. As long as their networks are capable of handling the increased order flow, they will likely be OK. With large-volume stocks, the drop from a $0.0625 floor to one as low as one penny presents a slight problem in loss of revenue per unit, but what of the less liquid companies that market makers sometimes have to hold in inventory awaiting a buyer?

These smaller volume stocks present a much higher risk, and as such they are normally traded with a much higher spread to compensate for their lack of constant liquidity. This spread is quoted as the "bid-ask," with the bid being what a seller would get at that moment and the ask being the price the buyer would pay. The difference between the two is kept by the market maker. For example, at this moment the quote for Southwest Airlines <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LUV)") else Response.Write("(NYSE: LUV)") end if %> looks like this:

Change    Last      Bid      Ask
 +1/16   16 5/8   16 9/16   16 5/8

With Southwest, the security is quite heavily traded, so the spread is at the minimum, 1/16. After decimalization, the spread would be allowed to close down as low as a penny for a company such as this. This is a positive for investors. On the flip side, however, is the potential for market makers to avoid less liquid stocks due to the carrying cost being higher than the potential return. However, as is the case today, what would likely end up happening is that those companies with lower trade volumes would retain higher spread intervals for the dealers who handle those securities.

What does this all mean to Fools? Not much and a lot, depending on your perspective. Some view this as another beneficial move, just like the advent of deep discount brokers, for the individual investor. Stock prices will be easier to discern and there is a substantial savings involved with removing a significant pricing inefficiency in the market. At the same time, investors who do not trade very much are unlikely to see a huge difference in trading costs. What will be interesting is whether mutual fund expense ratios will decrease in line with the cost savings the fund companies will conceivably receive from lower transaction frictions.

On the other hand, by creating additional efficiencies in the U.S. markets, the exchanges are doing something that will make our domestic markets just that much more attractive to foreign investment money. This added liquidity would put an increasing demand for the top securities available on our markets.

All in all, decimalization promises to be a good thing for U.S. investors and our markets. I even think that the market makers like Knight will come out OK in the deal, though I would expect these companies' stocks to become more volatile if the spread differentials do begin to shrink.

Fool on!