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March 1, 2001

Decimal Critics Wrong

By Harold Bradley

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Decimalization has arrived to a cascade of boos from buyside traders, spurred on by the Street's major block trading desks. Prices move with maddeningly slow speed, investors cannot see where "size" lives without a phone call to the floor, and institutions believe that orders are increasingly "gamed."

Changes to market structure often provoke this reaction. It reminds me of the early days when Instinet began to transform the way stocks traded in Nasdaq. Fat, lazy days of 1/4 and 1/2 spreads, accompanied by frequent stories of "XYZ" trading firm "in ahead" yielded over time to 1/256 spreads with lightening fast execution ability.

Behavioral finance emerged during the past decade with insights that most investors do not behave rationally as Nobel Prize winners assumed in the "Efficient Market Hypothesis." Traders and portfolio managers have relied on this "gut" intuition for generations as they scrutinize bullish consensus numbers, analysts' mean earnings estimates, and cycles of boom and bust. Rational and intelligent people often make bad judgments by using incomplete data to assess and manage risk.

Eighth Jumping!

I'm afraid that's where we are today in the reaction to the market's conversion to the decimal system. NYSE operatives began to whisper about "penny jumping" months before all stocks there traded in decimals. Traders recite that sound byte as a sort of mantra. Fears about "penny jumping" belie traders' failure to recognize that for years NYSE specialist and floor traders have "eighth jumped" with impunity.

The conversion to decimals shines a bright light on NYSE rules that mandate human intermediation - the specialist's hand - in every trade, and on a market that disdains price and time priority as an important feature of market quality. Now that we're trading in pennies, the "jumping" is just easier for all to see. And the "excuse" by brokers that they have been "jumped," is but another in a long list of oft-repeated explanations for a broker's lapse in judgment.

Many traders mistakenly assume that the NYSE operates on a price and time priority basis. Comment letters recently filed by the Investment Company Institute in response to Nasdaq's SuperMontage filing reiterated the buyside's strong consensus view that price and time priority is the most critical underpinning of market quality. Ironically, the lack of such cogent Nasdaq order interaction rules has been more readily apparent than at the NYSE. Much of the buyside backlash to decimals may be attributable to the startling revelation that the NYSE treats limit orders as "free options" for the floor and severely constricts the flow of information to investors about market depth.

Big Board Flipping

For years, NYSE exchange staff has focused on monitoring and controlling "flipping." The only price and time priority enforced on the NYSE floor applies to orders queued on the specialist book. Orders managed by brokers in the crowd are accorded a pro-rata "participation" right at a price, with no regard for time of order arrival. Minimum trading increments of 1/8 stimulated aggressive proprietary trading strategies based on the "free options" granted by those using limit orders.