Securities Pricing: Actions Needed for Conversion to Decimals (Testimony,
05/08/98, GAO/T-GGD-98-121).
Plans by the securities industry to convert computer systems to allow
trading in decimals rather than fractions are generally on hold. The
industry's resources are being devoted first to dealing with the Year
2000 problem, and industry officials believe that carrying out both the
Year 2000 and decimalization efforts at the same time would jeopardize
both. The securities markets have established a working group to expand
on earlier industry discussions about decimal trading, develop decimal
conversion standards, and set time frames for converting to decimals.
GAO found that making Year 2000 changes continues to require significant
resources from the securities industry and will demand much of the
limited time remaining for testing the changes. Ensuring the success of
these changes is too important for the industry to risk failure by
attempting to implement decimal trading before the Year 2000 changes are
made. However, GAO identifies several key elements that could help
ensure that the change to decimal trading is made as soon as possible
after January 1, 2000.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: T-GGD-98-121
TITLE: Securities Pricing: Actions Needed for Conversion to
Decimals
DATE: 05/08/98
SUBJECT: Securities
Proposed legislation
Systems conversions
Information resources management
Securities regulation
Computer software verification and validation
Stock exchanges
Strategic information systems planning
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Cover
================================================================ COVER
Before the Subcommittee on Finance and Hazardous Materials, Committee
on Commerce
House of Representatives
For Release on Delivery
Expected at
10:00 a.m., EDT
on Friday
May 8, 1998
SECURITIES PRICING - ACTIONS
NEEDED FOR CONVERSION TO DECIMALS
Statement of Thomas J. McCool
Director, Financial Institutions and Markets Issues
General Government Division
GAO/T-GGD-98-121
GAO/GGD-98-121T
(233554)
Abbreviations
=============================================================== ABBREV
ADR - American Depositary Receipts
EMU - European Monetary Union
NYSE - New York Stock Exchange
SEC - Securities and Exchange Commission
SIA - Securities Industry Association
TSE - Toronto Stock Exchange
SECURITIES PRICING: ACTIONS
NEEDED FOR CONVERSION TO DECIMALS
====================================================== Chapter SUMMARY
In 1997, this Subcommittee held hearings on proposed legislation that
would have directed the Securities and Exchange Commission (SEC) to
require that securities be traded using dollars and cents instead of
the traditional fractions within 1 year of enactment of the
legislation. After industry representatives indicated that they were
committed to converting to decimals, Congress took no further action
on the legislation. Industry progress since the hearings has
generally been limited. Four of the eight securities exchanges that
GAO contacted had begun converting their systems. Two of four
organizations GAO contacted that operated market support systems,
such as those that transfer payments and securities after a trade,
were in the process of converting their systems. One other was
finished, and another had not yet begun the conversion process. The
16 securities firms, market information vendors, and others that GAO
contacted had generally not yet begun their conversion efforts.
Officials of most of these organizations estimated that the cost to
convert their systems for decimal trading would be much less than the
cost for information technology efforts, such as the Year 2000
conversion. They also estimated that it would take less than 6
months to convert to decimals, but they did not expect to complete
the conversion until after Year 2000 changes have been tested and
implemented.
An industry study showed that the securities industry was dedicating
most of its available information technology resources and time to
readying its systems for the impending date change in 2000, the
introduction of a single currency in Europe in January 1999, and
other information technology initiatives. In particular, industry
officials said the time required to test and resolve any Year 2000
problems leaves little time for conducting the industrywide testing
necessary for a conversion to decimal trading. Industry information
technology officials warned that testing Year 2000 changes and a
decimal conversion at the same time would make it too difficult to
identify the source of any problems that might occur and would
increase the risks of failure for both. GAO's work reviewing the
Year 2000 efforts of numerous federal agencies and other entities has
generally found that organizations are avoiding the simultaneous
implementation and testing of multiple major systems changes to
mitigate the risk of inadvertent malfunctions.
Ensuring that securities industry systems are ready for the Year 2000
is too important to the continued functioning of the industry to risk
failure by attempting to implement decimal trading before the Year
2000 effort is completed. However, GAO is recommending several
actions that are needed to ensure that decimal trading is implemented
as soon as possible after January 1, 2000. These actions include
developing a comprehensive plan for implementing decimal trading that
would establish interim milestones, including those associated with
industrywide testing; setting an implementation target date; and
delineating technical standards and specifications that receive broad
industry support. The Securities Industry Association has agreed to
oversee and manage the project as it has done for Year 2000, but SEC
should monitor the plan's implementation. Further, decimal trading
may also have various effects on market operations, including placing
additional demands on the industry's information processing and
communications capacity and altering the functioning of various
market and exchange rules. To maintain fair and orderly market
operations, SEC needs to ensure that the industry also assesses and
prepares for these effects.
SECURITIES PRICING: ACTIONS
NEEDED FOR CONVERSION TO DECIMALS
==================================================== Chapter STATEMENT
Mr. Chairman and Members of the Subcommittee:
We are pleased to be here today to provide the results of our
assessment of the securities industry's readiness to trade stocks
using decimal prices. In 1997, your Subcommittee held a series of
hearings on a proposed amendment to the Securities Exchange Act of
1934 that would have directed the Securities and Exchange Commission
(SEC) to require, within 1 year of enactment, that securities trading
be in dollars and cents instead of the fractional increments of a
dollar, such as eighths and sixteenths, used today. Shortly after
those hearings, various exchanges and markets indicated that they
were committed to converting to decimal trading, and Congress took no
further action on the legislation. Subsequently, after market
participants indicated that the conversion to decimal trading should
be postponed until after 2000, you asked us to determine whether
anything could be done to accelerate that time frame.
With a few exceptions, the majority of the exchanges; market support
organizations, such as those that transfer payments and securities
after a trade; and securities firms of various sizes that we
contacted had made limited progress toward converting to decimal
trading. Most organizations were extensively involved in modifying
their systems to be ready for the date change in 2000 and the
impending implementation of the new European Monetary Union (EMU),
both of which have dates that cannot be changed. Market participants
expressed strong concerns that attempting to convert to decimal
trading while these and other information technology initiatives were
under way represented a great risk to the success of any of them and
to the industry as a whole. After consulting with SEC in January
1998, the securities markets established a working group to expand on
previous industry discussions of decimal trading and to begin
developing decimal conversion standards and establishing time frames
for completing the conversion to decimals. The time frames this
group has proposed envision that decimal trading would begin during
the third quarter of 2000.
Our work shows that making Year 2000 changes continues to require
significant securities industry resources and will demand much of the
limited time remaining for testing the changes. Ensuring that these
changes are successful is too important to the industry's continued
functioning to risk failure by attempting to implement decimal
trading before the 2000 changes are made. However, we identified
several key elements that could help ensure that the change to
decimal trading is made as soon as possible after January 1, 2000.
One of these elements was completed April 16, 1998, when the
Securities Industry Association (SIA) agreed to act as the industry
focal point for the implementation of decimal trading. The industry
has also been working on the other elements, but additional work
remains for SEC and the industry to reach consensus on the approach
for the implementation, as well as on an implementation date,
milestones, and technical standards and specifications. Further,
because decimal trading may have significant effects on U.S. markets
and market participants, assessing and addressing any such effects
would be an important part of preparing for and planning its
implementation. Potential issues include ensuring that adequate
processing and communications capability exists in the industry to
support decimal trading and evaluating any changes needed in market
regulations to ensure that market operations remain fair and orderly.
In doing this work, we contacted officials from SEC and eight major
exchanges and markets that trade stocks and options in the United
States as well as four support organizations for these markets, such
as those that transfer payments and securities after a trade. We
also contacted representatives from 12 securities firms of various
sizes as well as 2 organizations that provide information technology
support services for hundreds of additional firms. In addition, we
discussed the readiness for decimal trading with officials of two
major market information vendors. To obtain information from an
exchange that had recently undergone a transition to decimal trading,
we contacted the Toronto Stock Exchange (TSE). We also discussed
decimal trading with various securities market experts, including
academics who had conducted relevant studies. We did our work
between February and April 1998, in accordance with generally
accepted government auditing standards.
SECURITIES INDUSTRY PROGRESS
TOWARDS TRADING IN DECIMALS HAS
BEEN LIMITED
-------------------------------------------------- Chapter STATEMENT:1
Converting to decimal trading requires industry participants to (1)
identify those information technology systems and components involved
in securities trading that need changes, (2) make the necessary
software coding adjustments, and (3) test and validate those systems.
The testing is done in three phases--internally, externally with
individual counterparties (referred to as "point-to-point" testing),
and "streetwide" in which simulated trades are processed by all major
segments of the securities industry. As of April 30, 1998, only 2 of
the 28 organizations in the securities industry that we contacted had
converted and internally tested their systems for decimal trading.
(See app. I.) Although most of these organizations had not started
converting to decimals, they estimated that making the necessary
modifications and readying their systems for testing with others
would require less time and fewer resources than many of the other
initiatives already under way in the industry, such as the work being
done for the Year 2000 date change.
Of the eight stock and options exchanges we contacted, four had begun
system modifications. The farthest ahead was the New York Stock
Exchange (NYSE), which began its conversion 2 years ago to prepare
for listing and trading the ordinary shares of foreign companies
using decimal prices denominated in foreign currencies instead of the
American Depositary Receipts currently traded.\1 NYSE officials told
us they plan to complete system modifications by September 1998, when
internal testing is to begin. They said their conversion efforts do
not involve the accounting and processing systems used by NYSE
specialists.\2 One official said that NYSE has not formally attempted
to determine the readiness of specialists' systems for decimal
trading, but he indicated that some firms have begun converting. The
Nasdaq Stock Market, Inc. (Nasdaq), the American Stock Exchange, and
the Chicago Stock Exchange have begun replacing older systems with
newer technology that will be capable of decimal trading, and the new
systems are scheduled for completion and internal testing by the
third quarter in 1999. NASD Regulation, Inc. would not be ready
until March 2000. The other four exchanges generally had done only
internal assessments to determine which systems would require
modifications.
Of the 12 securities firms we contacted, only 1 had modified and
internally tested its systems for trading in decimals. Officials of
this firm said they had replaced their older systems with newer ones
that were capable of processing decimal prices. Many smaller
securities firms rely on third-party firms to perform their data
processing, but the two data processing firms we contacted--which
process information for hundreds of medium and small securities
firms--had not begun to modify their systems. Although most
organizations we contacted had not begun converting their systems for
decimal trading, many reported having at least conducted an informal
inventory or assessment of their systems to determine which ones
would be affected by such a conversion.
The readiness of the four market support organizations we contacted
varied. Officials of the largest U.S. securities depository
organization, the Depository Trust Company, which maintains records
of securities holdings for securities firms, custodian banks, and
their customers, said they had only one affected system and it was
already decimal ready. The Securities Industry Automation
Corporation, which operates the NYSE and American Stock Exchange
trading systems, also operates the systems that make up the National
Market System. These systems allow quotes and orders to be routed
among the exchanges in New York and other exchanges or dealers across
the country. According to Corporation officials, those systems that
route quotes are ready; those that route orders will be ready in the
third quarter of 1999. Officials of the National Securities Clearing
Corporation, which is the largest clearing organization for U.S.
stocks,\3 indicated that decimal trading modifications to the systems
used for exchange-listed stocks were completed in March 1998, but the
modifications for systems used for the stocks traded on Nasdaq are
not expected to be complete until May 1998. Officials at the Options
Clearing Corporation, which performs clearing functions for options
trading, told us that they had not yet begun systems modifications.
The time and cost estimates for converting to decimal trading offered
by exchanges, support organizations, and securities firms varied.
The estimates generally ranged from 2 to 6 months and no higher than
$10 million but usually closer to $5 million or less. Developing
cost estimates was difficult for many organizations, because they (1)
did not know the specifications, (2) had not yet started converting,
and (3) had to consider the impacts of other information technology
initiatives already under way at their organizations. An
industrywide study done for SIA found that the level of effort
required for securities market participants to ready themselves for
decimal trading was less than that required for other ongoing
information technology efforts.\4 For example, the study estimated
that decimal trading conversion industrywide would require slightly
over 300 person years, the equivalent of about $170 million, which is
less than 5 percent of the estimated 8,800 person years and about $5
billion for Year 2000 work.
--------------------
\1 American Depositary Receipts (ADR) are traded on U.S. exchanges
and markets in lieu of the actual shares of a foreign company. ADRs
are secured by a foreign company's shares held on deposit with a U.S.
bank and entitle their holders to all dividends and capital gains.
\2 Specialists are members of a stock exchange who are responsible
for maintaining fair and orderly markets in one or more securities.
\3 A clearing organization processes trade information for the
purposes of ensuring accuracy and facilitating the transfer of
payments and securities ownership.
\4 The Information Technology Capacity Study, Securities Industry,
(1998-2000), The Tower Group (Apr. 1998). The study received
responses from 10 of 22 large securities firms whose officials are
represented on the Technology Management Committee of SIA. The
results from these 10 firms were then used to estimate industrywide
resource requirements.
BARRIERS TO IMPLEMENTING
DECIMAL TRADING BEFORE 2000
EXIST
-------------------------------------------------- Chapter STATEMENT:2
Despite the less involved effort needed to convert individual firm
systems to decimals, securities market participants told us the
industry is unlikely to be able to implement decimal trading before
2000. The primary reasons cited were inadequate time and resources,
given the demands of the Year 2000 effort and other information
technology initiatives already under way.
Representatives of almost all of the exchanges, support
organizations, and securities firms we contacted indicated that they
would not have sufficient time and resources available to both modify
and test systems necessary for decimal trading until Year 2000
efforts were completed. Because decimal trading will affect all
market participants' systems, they said that systems changes would
have to undergo comprehensive streetwide testing similar to that
required for the industry's Year 2000 effort. Nasdaq officials noted
that the Year 2000 tests will be complex and that developing the
testing plan has required months of effort by large numbers of staff
across various organizations. NYSE officials indicated that most
organizations can conduct systems testing on only 2 weekends a month,
because processing associated with options expiration and the month's
end is done during the other weekends. Industry officials noted that
this is especially true for medium or smaller securities firms, which
lack dedicated testing systems and can test only at those times when
necessary business processing is not being done. TSE officials told
us that extensive testing was done as part of the exchange's
conversion to decimals and was a major factor in its smooth
transition.
Industry officials also expressed concerns about the risks of
converting to decimal trading while Year 2000 and other information
technology initiatives were under way. Most market participants told
us they have staff engaged in various other projects, including the
introduction of a new currency as part of EMU and a new order
tracking system required for trading on the Nasdaq market. Overall,
officials at 17 of the 24 organizations we contacted told us that
attempting to implement decimal trading before they were allowed to
complete Year 2000 efforts and other initiatives would increase the
risk of failure of one or more of the projects. For example,
officials at one exchange called the prospect of converting their
systems for decimal trading while Year 2000 efforts were under way
"frightening," and they questioned whether the benefits were worth
the potential damage that could result if systems do not work
correctly and markets were unable to trade. Representatives of at
least five organizations also warned that making simultaneous changes
to multiple system variables, such as to both prices and dates, was
not a prudent practice and would make identifying and correcting any
resulting processing errors very difficult. Officials at one
exchange also indicated that making modifications for both 2000 and
decimals would make it difficult for them to certify that their
systems were Year 2000 compliant. Further, our work reviewing the
Year 2000 efforts of numerous federal agencies and other entities has
generally found that organizations are avoiding the simultaneous
implementation and testing of multiple major systems changes to
mitigate the risk of malfunctions.
Officials from most of the organizations advised us that obtaining
the necessary internal and external resources for conducting
information technology projects is extremely difficult, largely
because such resources are already working on either Year 2000
efforts or the other industrywide initiatives. For example,
representatives at four organizations said that they intended to use
the same staff to convert to decimals that they are using for Year
2000 work now. Officials from one large securities firm said that
the work entailed in converting systems for decimal trading requires
an understanding of internal systems and the information flows among
them and cannot be done by less experienced staff or external
resources. Staff capable of performing this work are already engaged
at their firm doing Year 2000 and EMU modifications. Officials at a
smaller securities firm noted that unlike decimal conversion, many of
these other initiatives stem from regulatory mandates or have
externally fixed implementation dates, such as 2000 and the EMU
target in 1999.
KEY ELEMENTS REQUIRED FOR
SUCCESSFUL IMPLEMENTATION OF
DECIMAL TRADING
-------------------------------------------------- Chapter STATEMENT:3
The readiness of the securities industry to convert to decimal
trading has been hampered by the lack of certain key elements
necessary for successful implementation. One of these elements was
completed on April 16, 1998, when NYSE informed SEC that SIA had
agreed to act as the industry focal point for the implementation of
decimal trading. The industry had also begun work on the other
elements, however, no SEC and industry consensus has been reached on
the technical standards and specifications to be used by individual
organizations in converting their systems or on implementation plans
and time frames.
For other industrywide information technology projects, such as the
Year 2000 efforts, a central organization or planning group was
responsible for overseeing and coordinating the various participants'
efforts. SIA has served as the coordinating body for the
industrywide efforts under way for the Year 2000 project. An NYSE
official said that for a conversion to decimal trading to go
smoothly, leadership from an organization like SIA would help to
focus the industry's efforts. SIA officials told us that they would
be willing to perform this role for the industry using the same
committee structure and organization that they have used for the
industry's Year 2000 preparations; and on April 16, 1998, agreed to
do so.
Developing an industrywide consensus on standards and specifications
needed for decimal trading involves determining how many decimal
places each organization's systems should be prepared to recognize
and how rounding of prices would be done. Officials at six
securities firms and one information processing firm told us that
they would not begin converting their systems until standards and
specifications for decimal trading had been established. Obtaining
consensus from a broad range of organizations affected by these
standards will also be important. For example, officials from one
securities firm told us that after a set of standards is proposed, a
working group of systems experts should provide input before such
standards are finalized. They said that although the specifications
for decimal trading will not be that complex, ensuring that they are
workable for all organizations will require review by technology
officials throughout the industry.
Developing an overall plan for decimal trading involves reaching
consensus on how the transition will occur and what the
implementation date will be. Officials of at least six organizations
emphasized that determining the approach for implementing decimal
trading was an important step. Some suggested that the approach
might entail a phasing in of selected stocks; others suggested that
all stocks and markets could convert at once. In addition, officials
at many of the exchanges and securities firms we contacted emphasized
the importance of establishing a target date for implementation. Six
organizations indicated that they had delayed the start of any
efforts to convert their systems for decimal trading, because such a
date had not been set. Developing individual organization plans
includes designating a project manager and identifying technical and
management points of contact in core business areas, as suggested in
our Year 2000 assessment guide.\5
The industry has begun taking some of the steps necessary for
successful implementation of decimal trading. An SEC official told
us that SEC met with the exchanges, Nasdaq, and clearing
organizations in June, and again in September 1997, to discuss the
process needed to begin decimal trading. Also, NYSE's Operations
Advisory Committee, an industrywide group comprising a broad range of
securities firms, met in September 1997 to discuss these issues. In
January 1998, SEC requested that NYSE convene a small working group
to propose a plan for the industry's conversion to decimal trading.
On February 27, 1998, representatives from various exchanges began
holding meetings to discuss the timing and standards for implementing
decimal trading in U.S. markets. This group has developed
preliminary standards for converting systems for decimal trading,
including specifying prices with 2 decimal places. The group also
suggested that system changes to accommodate decimals should be able
to handle at least 4 places as a precautionary measure for future
contingencies. In addition, the group has offered a potential
timetable for implementing decimal trading that would call for
initial testing among individual participants during January to May
2000, industrywide testing through July 2000, and implementation
beginning September 2000. Further, the group has discussed a plan to
revert to fractions from decimals if serious processing problems
arise when decimal trading begins. The group presented the proposed
plan to SEC for approval in April 1998. SEC officials told us that
they have asked the group to adjust the time frames in an effort to
have implementation of decimal trading begin by June 2000. However,
officials at two firms we talked to said that even being ready by
third quarter 2000 might not be possible. Although the members of
this group are important to the implementation of decimal trading in
the securities industry and have agreed on specifications and a
testing timetable, additional work remains to achieve industrywide
consensus on these elements.
--------------------
\5 Year 2000 Assessment Guide, (GAO/AIMD-10.1.14, Sept. 1997).
ASSESSING AND PLANNING FOR THE
EFFECTS OF DECIMAL TRADING
-------------------------------------------------- Chapter STATEMENT:4
Assessing and planning for the effects of decimal trading on
investors, exchanges, securities firms, and the markets themselves
could help ensure that implementation is successful. Converting to
decimal trading is generally expected to result in lower spreads for
stocks,\6 although many market participants were skeptical that the
savings for investors anticipated by some advocates would actually be
achieved. Market participants also expressed concerns about the
effect of decimal trading on certain aspects of market operations,
such as processing capacity and market rules.
--------------------
\6 The spread is the difference between the lowest price at which an
investor is willing to sell stock and the highest price at which an
investor is willing to buy stock. Narrowing the spread can provide
both lower buying and higher selling prices for investors. When an
investor buys or sells stock from a dealer, the spread represents
revenue to the dealer.
DECIMAL TRADING EXPECTED TO
REDUCE SPREADS BUT MAGNITUDE
OF SAVINGS UNCERTAIN
------------------------------------------------ Chapter STATEMENT:4.1
Predicting the specific savings that may result by converting to
decimal trading is difficult, because the conversion may also affect
market variables, such as the number of shares offered to buy or
sell, commissions, trading patterns, and individual investor
behavior. However, to the extent that decimal trading reduces
spreads, public investors potentially could save money on their
trades.
Advocates of decimal trading have estimated that savings for
investors could be considerable if the conversion results in lower
minimum price change increments (tick size) and subsequently lower
spreads. Estimates of the annual savings possible from a conversion
to decimal trading in U.S. markets range from $300 million to $5
billion. One simply derived estimate used the 250 billion shares
traded in 1996, adjusted for 100 billion shares traded that did not
involve dealers, and estimated that U.S. investors would benefit by
$1.5 billion for every 2 pennies that spreads decline. Another
estimate was derived from the experience of TSE in its decimal
conversion. According to information provided by TSE, spreads on the
largest stocks declined 37 percent after the conversion to decimals.
One academic researcher estimated the savings for investors from this
change were about $216 million (Canadian dollars) each year.
Projecting these results to U.S. markets, he estimated that decimals
could save investors $2.25 billion each year on the New York and
American Stock Exchanges.
Many of the market participants we contacted agreed that some savings
for investors may result from the lower spreads likely to accompany
decimal trading. They doubted, however, that all of the projected
savings would be achieved. Savings from decimal trading may be less
than expected for the following reasons.
-- Previous reductions in the minimum tick size have already
captured some of the savings expected from decimal trading. On
June 2, 1997, the Nasdaq market reduced its tick size from 1/8th
to 1/16th; and NYSE made a similar reduction on June 24, 1997.\7
This represented a decrease from $0.125 to $0.0625 in the
minimum increment by which prices could change. One study of
the effects of the decrease at NYSE indicated that the savings
to investors, after adjusting for trades that do not involve a
spread, may have been as much as $1 billion a year.\8 The
further savings achievable by converting to decimals depend on
the trading increments used. Some market officials indicated
that if spreads only narrow to $0.05 after the conversion to
decimal prices, the bulk of the expected savings may already
have occurred.
-- Significant portion of trades on exchanges do not involve the
payment of spreads. The projected savings from conversion to
decimal trading could be less than projected by some estimates
because not all trades currently involve the payment of a spread
by an investor to a securities firm acting as a dealer. For
example, the study of NYSE's tick size reduction to 1/16ths
discussed above originally projected daily savings in
NYSE-listed shares that would equate to as much as $5 billion
annually. However, the study's author later reduced his daily
estimates to amounts that equate to as much as $1 billion
annually, because only about 20 percent of the volume on NYSE
directly involve a specialist and could result in the payment of
a spread.
-- Some portion of trades on the Nasdaq market also do not involve
the payment of spreads. Although trading on the Nasdaq market
directly between customers and dealers acting as market makers
potentially involves the payment of a spread, estimates of
projected savings for decimal trading will also have to be
reduced to account for the trades that take place within the
spreads. For example, one academic researcher stated that about
20 percent of the Nasdaq volume is dealer-to-dealer trading and
thus would not represent a potential source of savings for
investors.\9 In addition, another 20 percent of the total volume
of trades are between public investors as block trades or on
electronic communication networks such as Instinet and do not
involve payment of a spread. In addition, this researcher
estimated that another 30 percent of the volume represents the
activities of institutional investors that commonly negotiate
their trades at prices between the quoted spread. He concluded
that only 30 percent of Nasdaq trading would potentially benefit
from smaller spreads. Using these adjustments for the various
types of Nasdaq trading, as well as similar adjustments for NYSE
and other exchange-traded stocks, he calculated a maximum
potential annual savings of about $300 million for every penny
the spread is reduced.
-- Effect on spreads may not be the same for all stocks. Some
studies have found that minimum tick sizes may artificially
constrain the spreads on actively traded, high-volume stocks.
Therefore, smaller tick sizes could reduce the spread on these
stocks. However, officials at various organizations noted that
decimal trading will not necessarily reduce spreads to the
minimum for all stocks. Spreads for individual stocks are
influenced by many factors, such as the liquidity of the stock
or the investor demand for it. For some stocks, SEC officials
anticipated that spreads may actually be wider than before,
because the natural spread for the stock may be between two
fixed minimum price increments. Furthermore, a securities firm
official said that stock trades do not always occur at the
minimum possible spread because of normal fluctuations in supply
and demand.
--------------------
\7 The American Stock Exchange reduced its tick size from 1/8th to
1/16th for all listed securities on May 7, 1997. It had reduced its
tick size to 1/16th for securities priced under $5 in September 1992,
and expanded the securities eligible for trading in 1/16ths to those
under $10 in April 1995.
\8 "A Teeny Change at the NYSE: Is the Move to 16ths Paying Off as
Expected?," ITG Advance, Investment Technology Group (New York, NY:
Aug. 1997).
\9 Testimony on H.R. 1053: The Common Cents Stock Pricing Act of
1997, Lawrence Harris, Marshall School of Business, University of
Southern California (Los Angeles, CA: Apr. 16, 1997).
INFORMATION HANDLING
CAPACITIES MAY BE STRAINED
------------------------------------------------ Chapter STATEMENT:4.2
The systems capacities of various market participants may be strained
if decimal trading causes similar increases in processing and
communication volumes, as the change to 1/16ths did. (See app. II.)
Market participants told us that converting to decimal trading is
likely to increase processing and communication volume, because such
increases resulted when the tick size was reduced to 1/16ths in June
1997. Every exchange and large securities firm we contacted
indicated that their systems experienced increased processing volumes
following the reduction in the minimum trading increment from 1/8th
to 1/16th. For instance, according to its officials, NYSE
experienced as much as a 40-percent increase in message traffic
following the conversion to 1/16ths. Officials attributed these
increases to the doubling of the number of fractional increments of a
dollar at which trades could be executed from 8 to 16, which produced
more quotes and more trades of smaller size. They anticipate similar
increases from a conversion to decimals, which could result in 100
such increments if trading is done in pennies.
Over the course of the last year, almost all of the various exchanges
and market participants we contacted had experienced information
processing problems, which most attributed to these increased
processing and communication volumes. Although some organizations
told us that they experienced problems right after the tick size
reduction, the problems became most severe during October 1997, which
saw record trading volumes on U.S. markets. That month, both NYSE
and Nasdaq traded over 1 billion shares in 1 day.
Some of the problems encountered during this time included delays
within the systems that make up the National Market System. For
example, the communications network used to route price quotations in
listed securities among markets and other data vendors experienced
queuing problems on 29 occasions between June 1997 and the end of the
year, including estimated delays of up to 1 minute at various times
during the record trading days in October 1997. Officials
responsible for the operation of this system reported that a new,
higher capacity network became fully operational on January 2, 1998,
and, that, with two exceptions, they expected all data recipients to
have migrated to the new network by the end of May 1998. The Nasdaq
market also experienced problems in October, when one of the systems
used to provide confirmation of trades went down for several hours.
Nasdaq officials reported that they made changes to correct these
problems the same day, and no operational effects on trading
resulted. Many of the securities firms we contacted also experienced
processing related problems in 1997. One representative said that
his firm spent $10 million making its clients whole as a result of
processing problems it had with its internal systems and those of the
various markets during those high-volume trading days.
As a result of these problems, market participants indicated that the
industry will have to address capacity issues for trading both
equities and options if the implementation of decimal trading is to
be successful. Options exchange officials said that capacity
concerns may be even more important for options trading because of
the large quote traffic that options generate for exchanges, market
participants, and vendors. Many of the organizations we contacted
had plans to, or had already begun to take steps to, increase their
systems capacities. Because of the problems experienced after the
reduction in tick size to 1/16ths, one exchange official indicated
that converting to decimal pricing before an industrywide capacity
study was made would be unwise. Two of the organizations that are
responsible for managing major national market systems have recently
commissioned an outside consultant to develop a comprehensive
capacity planning process for those systems. SIA officials advised
us that a similar study is expected to be commissioned for assessing
the impact of a conversion to decimal trading later in 1998.
MARKET OPERATIONS AND RULES
MAY CHANGE TO ACCOMMODATE
DECIMAL TRADING
------------------------------------------------ Chapter STATEMENT:4.3
Converting to decimal trading could also affect the functioning of
various market rules.\10 Some of the first rules affected would be
those that establish the minimum allowable tick size in the various
markets. Exchange and Nasdaq rules that denominate the minimum tick
on their markets in fractions (usually 1/16) would at least have to
be converted to decimals. Also, the appropriate tick size may be
less than the fractional equivalent of the existing minimum tick
(0.0625), or the rules could specify no minimum and allow tick size
to be set by competition.
Among the rules most affected by the smaller tick sizes that decimal
trading could provide are those that stipulate order priority.
Market participants expressed concerns that ticks approaching pennies
could increase the prevalence of "order-jumping." Order-jumping
occurs when a trader submits an order that improves the price by a
small amount and thus obtains priority over any limit orders waiting
to be executed.\11
The investors whose limit orders then go unexecuted either do not
trade or must resubmit their orders at less advantageous prices. As
a result, the use of limit orders may be discouraged over time, and
may reduce market liquidity and make markets less transparent. SEC
and exchange officials told us that this issue will have to be
assessed, and revised rules may be needed to mitigate its impact.
For example, one way to protect investors that submit limit orders is
for the exchanges and Nasdaq to establish rules that require
professional traders wishing to trade ahead of their customers'
orders to submit such orders at a higher increment than the minimum
increment used for trading.
Other rules that market participants indicated could be affected by
decimal trading are those requiring that trades by all exchanges or
dealers be executed at the best prices prevailing across markets.
For example, officials at one exchange told us that if spreads are as
low as a penny, requirements that trigger automatic executions at the
best prices will have to be changed to prevent manipulation. This
could occur when a trader posts a quote for, or trades, a small
volume of stock in one market to influence the prices in another
where he intends to simultaneously trade a larger volume of stock.
Other participants noted that with penny ticks, conducting trades
that affect the functioning of the short sale rule would be
easier.\12 Currently, trades conducted for the purpose of selling a
stock short are allowed to be executed only if the last trade
occurred at a higher price than the one prior (an uptick). With
smaller ticks, manipulating the market to ensure that such a higher
priced trade occurs before selling short would be less costly and
easier to accomplish.
As a way of providing SEC and market participants an opportunity to
address any negative effects of decimal trading, some industry
officials suggested that the implementation be phased in, beginning
with a limited number of stocks. They suggested that a minimum tick
size of $0.05 could initially be mandated and assessed before
additional stocks are included and further tick size reductions are
permitted. SEC officials told us that assessing market effects is
always difficult, even during a phase-in period. They said that they
have not endorsed a phased implementation approach, although such an
approach may help ensure that any systems-related or technical issues
are corrected before decimal trading for all stocks occurs. They
added that if the industry requests phased implementation, the
phase-in period should be short and specifically set, and not used to
unnecessarily extend the process.
--------------------
\10 Appendix III provides additional detail on some of these and
other impacts that market participants have projected may result from
the implementation of decimal trading in the United States.
\11 A limit order is one that is to be executed only if the trade
price is equal to or better than the price designated in the order.
Such orders establish a maximum price at which an investor is willing
to buy a stock or a minimum price at which an investor is willing to
sell.
\12 Short sales occur when investors borrow shares of a stock that
they do not currently own from other investors and then sell those
shares. Such investors profit when the stock's price declines and
they are able to repurchase the shares at a lower price to replace
the ones they borrowed.
CONCLUSIONS
-------------------------------------------------- Chapter STATEMENT:5
The continued health and smooth functioning of U.S. securities
markets is vital to the nation's economy and depends on the industry
making Year 2000 changes successfully. Attempting a conversion to
decimal trading before Year 2000 changes are tested and implemented
increases the risks that securities industry systems would fail and
adversely affect markets and investors. Achieving the potential
benefits of decimal trading for investors before 2000 does not appear
worth the risk.
SEC and the securities industry have been working on several elements
that are necessary to help ensure the successful implementation of
decimal trading as soon as possible after January 1, 2000. However,
additional work remains to obtain industrywide consensus on the plan
and targeted implementation date; the standards and specifications;
and the schedule for internal, point-to-point, and industrywide
testing. Obtaining final agreement on these elements requires
detailed planning for all the entities in different industry
segments, including the stock and options markets, supporting
organizations, securities firms, and processing and market data
dissemination firms.
Assessing and preparing for the potential effects of decimal trading
on ongoing market operations would increase the likelihood that the
conversion will be successful. Such effects might include increased
strain on industry processing and communication capacity or reduced
price ticks and spreads that may require modifications or additions
to market rules. Preparing for these effects might involve phasing
in certain numbers of stocks at specified minimum ticks, as some
market participants suggest, or closely monitoring the effects of
trading to be ready to quickly make necessary changes to maintain
fair and orderly markets.
RECOMMENDATIONS
-------------------------------------------------- Chapter STATEMENT:6
To help ensure a successful implementation of decimal trading in U.S.
equities markets as soon as possible after January 1, 2000, we
recommend that the Chairman, SEC, take the following actions:
-- The Chairman should ensure that market participants develop a
comprehensive plan for implementing decimal trading. Such a
plan should establish interim milestones, including those
associated with streetwide testing; set an implementation target
date; and delineate technical standards and specifications that
receive broad industry support. Although the Securities
Industry Association has agreed to oversee and manage the
project as it has done for Year 2000, SEC should monitor the
plan's implementation.
-- The Chairman should also ensure that an assessment is conducted
of the potential impact of decimal trading on (1) the industry's
processing and communication capacity and (2) the functioning of
market regulations and exchange rules so that any necessary
changes can be made and a smooth transition to decimal trading
can occur.
DECIMAL TRADING READINESS STATUS
FOR SELECTED SECURITIES MARKET
PARTICIPANTS
=========================================================== Appendix I
Many organizations had not begun converting to decimals, because
standards and specifications and an implementation date had not been
established. Most considered Year 2000 and EMU changes their top
information technology priorities.
Market Participant Status of effort to convert?
----------------------- ---------------------------------------------
Exchanges
----------------------------------------------------------------------
New York Stock Exchange Started conversion 2 years ago, and plan to
complete internal testing by the end of 1998.
Nasdaq Replacing old systems with new that will be
decimal ready.
American Stock Exchange Inventory conducted, budgeted, and plan being
developed. Some trading systems being
replaced that will be decimal ready.
Boston Stock Exchange Preliminary analysis of project but have not
begun process. Waiting for specifications.
Chicago Stock Exchange As part of system modernization, have begun
converting.
Pacific Exchange Conducting inventory and have budgeted.
Philadelphia Stock Some scoping but have not begun formal
Exchange process.
Chicago Board Options Conducted inventory, budgeted, and have plan.
Exchange
Market Support Organizations
----------------------------------------------------------------------
Depository Trust Had only one affected system, which was
Corporation already decimal ready.
National Market Systems Quoting (CQS) and trade reporting systems
(Securities Industry (CTS) decimal ready now. Intermarket trading
Automation Corporation) system (ITS) modifications under way.
Options-related systems have not begun to be
converted.
National Securities Systems for exchange-traded stocks completed
Clearing Corporation in March 1998. Systems for Nasdaq-listed
stocks to be completed by May 1998.
Options Clearing Conducted preliminary inventory.
Corporation
Broker-Dealers
----------------------------------------------------------------------
Bear Stearns Have not begun process.
Goldman Sachs Only performed quick issue assessment last
year.
Merrill Lynch Performed preliminary assessment, will not
start until Year 2000 is complete, many
systems decimal ready.
Morgan Stanley High level assessment of scope.
Paine Webber Previously performed a preliminary
assessment, will not start until have
specifications.
Salomon Brothers Preliminary assessment of scope.
Advest Have not begun process.
Gruntal Internal systems completed but its clearing
firm provides systems that are not ready
Lynch Jones Ryan Processing done by vendor that is not ready.
Bernard L. Madoff Taken ancillary look but no inventory,
Securities budget, or plan. Instead, project is part of
ongoing systems development.
Processing/Clearing Organizations
----------------------------------------------------------------------
Automatic Data Have not begun process.
Processing
Pershing Have not begun process.
Market Information Vendors
----------------------------------------------------------------------
Bloomberg Have not begun process but minimal effort
required.
Reuters Have not begun process.
----------------------------------------------------------------------
DECIMAL TRADING'S IMPACT ON
INDUSTRY INFORMATION PROCESSING
AND COMMUNICATIONS CAPACITY
========================================================== Appendix II
The implementation of decimal pricing within the securities industry
may lead to increased processing and communication volumes, because
such increases resulted from the reduction in tick size to 1/16ths.
All of the exchanges we contacted, along with representatives of
organizations that provide information processing for the national
market system, indicated that their systems experienced increased
processing volumes and operated at greater capacity levels following
the reduction in the minimum trading increment from 1/8th to 1/16th.
They also indicated that they experienced information processing and
communications-related problems during the record trading volumes
that were reached in October 1997.
According to NYSE officials, that exchange experienced as much as a
40-percent increase in message traffic following the conversion to
1/16ths. They attributed these increases to the doubling of the
number of potential price points from 8 to 16, which likely
encouraged traders to submit larger numbers of smaller orders in an
attempt to achieve the most favorable pricing. Additional message
traffic was created by traders who increased the practice of
cancelling and resubmitting orders as a way of attempting to
ascertain the direction of price movements. Analysis of data
provided to us by NYSE shows that the number of one type of
message--price quotes--almost doubled, rising 92 percent from 1996 to
1997; 1997 trading volume on the exchange increased just 27 percent
from the prior year. On Nasdaq, which also experienced increases
because of new SEC rules that introduced more quotes to the Nasdaq
system, quotation volumes rose 84 percent as they increased from
about 6.6 million messages in January 1997 to over 12.1 million in
July 1997. The message volume increased further from there, peaking
at over 20 million quotes in October but remaining as high as 16
million in December 1997. In contrast, although Nasdaq's trading
volumes increased 19 percent in total from 1996, Nasdaq began and
ended the year trading 14 billion shares, with volume peaking in
October at 18 billion.
During the record volumes in October 1997, Nasdaq also experienced
problems with one of its trading systems. On October 28, 1997, the
day when Nasdaq achieved a record trading volume of about 1.4 billion
shares, the system used to provide confirmation of trades was
operational, but unavailable for user inquiry for several hours.
This problem did not stem from a lack of processing capacity but
instead was due to a programming restriction that had limited the
number of individual buys and sells to a number under 1 million a
day. However, this number of transactions was exceeded at about 3
p.m. that afternoon, after which the system continued to process
trades but was no longer available to traders for confirmation that
their trades had been executed. Nasdaq has since made changes to its
confirmation system to address these problems, including raising the
programming restriction to 10 million a day. Nasdaq officials also
said they have begun expending about $600 million to upgrade their
communications network because of the increased processing demands
resulting from the conversion to 1/16ths and the increasing trading
volumes being experienced in the market.
The system that provides quotations for the National Market System
also experienced significant information processing and
communications problems following the reduction in tick size from
1/8ths to 1/16ths. For example, the communications network used to
route price quotations in listed securities among markets and other
data vendors experienced queuing problems on 29 occasions between
June 1997 and the end of the year, including estimated delays of up
to 1 minute at various times during the record trading days in
October 1997. Officials responsible for the operation of this system
reported that a new, higher capacity network became fully operational
on January 2, 1998, and, that, with two exceptions, they expected all
data recipients to have migrated to the new network by the end of May
1998.
These queuing problems were primarily attributed to significantly
increased quotation traffic resulting from a combination of normal
growth and two external factors, the new SEC rules in January 1997
and the reduction in the minimum price change increment from 1/8ths
to 1/16ths in June 1997. Following the reduction in the price
increment, the average daily message traffic of the quotation system
increased by about 300,000 messages. The introduction of 1/16ths
caused an overall reduction in the processing capacity of the
communication network supporting the quotation system, because the
use of 1/16ths required a long message format (94 bytes); the use of
1/8ths allowed the use of a short message format (40 bytes).
DECIMAL TRADING PROJECTED TO HAVE
VARIOUS IMPACTS ON MARKETS AND
MARKET PARTICIPANTS
========================================================= Appendix III
Market participants and others indicated that the implementation of
decimal trading in U.S. markets could have a wide range of effects
on the markets themselves and on the participants in them. The
following presents some of the projected effects that were described
to us by regulators, exchange and securities firm officials, and
market experts. We also discuss the effects contained in various
analyses and studies of U.S. and foreign markets that addressed
issues relevant to decimal trading.
One of the effects seen by market participants from the
implementation of decimal trading in U.S. markets was an increased
use of a trading strategy known as "order-jumping." This occurs when
a trader submits an order that improves the price by a small amount
and thus obtains priority over any limit orders waiting to be
executed. Officials at various exchanges and securities firms
expressed concerns that if minimum ticks or spreads decline to
pennies, the use of this strategy will become more commonplace,
because the risk of loss associated with it would generally be
limited to the level of the minimum tick. This is because
order-jumping traders can usually reverse their positions quickly by
submitting an order to be executed against the very same order they
jumped in front of, thus incurring a loss of only the size of the
tick or the increment by which they originally achieved priority.
The ultimate effect of increased instances of this strategy is not
clear. Although the investor whose order interacts with orders that
only slightly improve the prevailing price is better off, any
investors whose limit orders then go unexecuted or have to be
cancelled and resubmitted at prices less advantageous to those
investors are worse off. As a result, some of the benefits of
decimal trading may be offset by losses to those investors whose
limit orders lost priority, and may discourage the use of limit
orders over time.
Market participants also indicated that a conversion to decimal
trading could affect the overall quality of U.S. markets. Numerous
exchanges and securities firm officials indicated that decimal
trading was likely to reduce the amount of liquidity in the markets,
although the results of various analyses produced unclear results as
to whether markets that reduced their tick sizes experienced overall
declines in market liquidity. The studies we reviewed of U.S. and
foreign markets that reduced their tick sizes generally confirmed
that fewer shares were available at the best prices after such
reductions than before. However, whether overall liquidity was
reduced is unclear. According to statistics provided to us by TSE,
after it reduced its minimum tick size from 1/8th to $0.05, the
number of shares quoted for purchase or sale at the best prices
declined over 60 percent for the top 35 stocks and by at least 33
percent for the top 300 stocks. However, TSE officials reported that
approximately the same volume of shares is offered as before, but the
volume is just spread over more price levels.
Another effect that market participants discussed was that decimal
trading could reduce the number of securities firms willing to make
markets in stocks if it reduces profitability. An official from a
medium-sized securities firm told us that his firm has already
reduced the number of Nasdaq stocks that it makes markets in as a
result of lower profitability. He indicated that investors could be
negatively affected as further narrowing spreads will lower the
rewards but not the risks to dealers. In his opinion, tick sizes of
a penny would dramatically affect the economics of market making, and
this could make it more difficult for smaller emerging companies to
access the capital markets if the returns to securities firms for
making markets in such stocks do not match the risks. At least five
of the securities firms we contacted had recently reduced the number
of listings in which they made markets, including one large
securities firm whose officials told us that they had reduced the
number of stocks for which they made markets from about 850 to 550.
NASD officials, although not providing exact statistics on the number
of market makers, indicated that some firms had reduced the number of
stocks for which they made markets, but other firms had increased
their market-making activities, and thus no large net impact had
resulted. However, a securities firm official noted that when a
smaller firm begins making markets in the stocks dropped by a large
firm, the costs to investors are not likely to be as low.
The impacts of a conversion to decimal trading on overall securities
firm profitability were not clear and may vary across the activities
of the firms. As noted above, the profits of firms that make markets
in Nasdaq stocks would likely be further reduced by any additional
narrowing of spreads brought about by decimal trading. Officials at
two medium-sized securities firms indicated that their firms'
market-making activities are no longer operated for the purposes of
producing profits from such trading. Instead, the activities are
maintained as part of providing services to customers that also use
these securities firms for corporate finance and other purposes.
Decimal trading's potential impact on profits, however, may not be
negative for all dealers. For example, one study of TSE's conversion
to decimals and reduction in tick size found no measurable change in
gross trading revenues for member securities firms.\13 According to
officials in NASD's Economic Research Department, this suggests that
decimal trading on TSE led to no net benefit to public investors
because those investors that submit limit orders have lost at the
expense of those that submit orders to buy at the prevailing market
price.\14 Furthermore, officials at three organizations told us that
securities firms acting as specialists on the floors of NYSE, the
American Stock Exchange, and other exchanges may actually experience
increased profits if a move to decimal trading brings smaller tick
sizes. This is because these firms would be able to participate in
more trades without violating rules requiring that customer orders
receive priority over the specialist's own trading. According to
information reported by NYSE, specialist firm profits were a record
$268 million in 1997, which was an increase of 33 percent from the
prior year.
Various market participants also projected that decimal trading would
increase market volatility. However, the impact of any further tick
size reductions arising from decimal trading on overall market
volatility is not clear, because a smaller tick size is likely to
lead to more frequent, but smaller, price changes. The Investment
Technology Group's study of the U.S. market's move to 1/16ths found
that volatility as measured by price changes from trade to trade had
actually declined by almost 20 percent. We did not identify other
studies that attempted to show whether the overall level of market
volatility has changed over the last year or not.
Market participants also indicated that the implementation of decimal
trading could affect the functioning of various market rules.
Currently, trades conducted for the purpose of selling a stock short
are allowed to be executed only if the last trade occurred at a
higher price than the one prior (an uptick). With smaller ticks,
manipulating the market to ensure that such a higher priced trade
occurs before selling short would be less costly and easier to
accomplish. Various rules also currently exist that require trades
to be executed at the best prices prevailing across markets. For
example, officials at one exchange told us that if spreads are as low
as a penny, requirements that trigger automatic executions at the
best prices will have to be changed to prevent manipulation. This
could occur when traders post quotes for, or trade, a small volume of
stock in one market to influence the prices in another where they
intend to simultaneously trade a larger volume of stock.
--------------------
\13 Decimalization and Market Quality, Daniel G. Weaver, Marquette
University (Milwaukee, WI: Mar. 1997).
\14 Issues Relating to the Decimalization of the Nasdaq Stock Market,
NASD Economic Research (Washington D.C.: Sept. 11, 1997).
*** End of document. ***