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April 1, 2001

Decimals Narrow Spreads in Early Days

By Editorial Staff

The pilot launch last month of 14 Nas daq stocks trading in decimal prices cut spreads by half in the first three days, according to preliminary statistics compiled by the Nasdaq Stock Market.

Overall, both quoted spreads and effective spreads fell by about half, Nasdaq noted. Quoted spreads measure costs for retail investors using small market orders; effective spreads are calculated as twice the absolute difference between the actual trade price and the prevailing bid-ask mid-point.

Nasdaq began the transition to decimal pricing on March 12. The market implemented decimal trading for another 177 companies with 199 associated securities on March 26. All Nasdaq securities are scheduled to trade in decimals starting on April 9.

More Data

Additional data from the first 14 decimalized Nasdaq stocks showed an average decrease in the number of trades, but an increase in trade size, according to the preliminary findings.

Usage of SelectNet and SOES has not varied significantly so far, according to a spokesman for Nasdaq. Some observers had suggested decimalization might change usage patterns for those systems, said the spokesman Scott Peterson.

Establishing the cause for these effects is problematic because the Nasdaq decimalization effort is young. Peterson said Nasdaq plans more analysis as decimalization continues. Indeed, he said, Nasdaq's economic research department is reviewing all decimal studies as markets abandon fractional pricing.

At least one observation from Nasdaq's experience has been confirmed elsewhere. Robert Wood, professor of finance at Tennessee's University of Memphis, recently documented a 36 percent reduction in quoted bid-ask spreads for a group of decimal-priced stocks on the New York Stock Exchange. He compared them with a control group of fraction-priced NYSE stocks.

Wood said NYSE decimalization apparently removed a barrier to price competition when the market switched from pricing stocks in 1/16th increments to pricing in pennies. That same barrier did not fall after the switch from pricing in 1/8th increments to 1/16ths, he noted.

Wood's report stated: "[E]ven though the cumulative changes in the bid and offer quotes between decimal and control stocks at an 1/8th or less are almost identical, all penny ticks in between appear to be hit by the decimal stocks and, especially comforting to the supporters of decimal pricing is the fact that, quote increments of five cents or less appear to be used actively by the market in the decimal stocks.

"The latter may also indicate that 1/8th and 1/16th minimum tick sizes may have represented barriers to price competition which have been ameliorated with decimal pricing."

Another decimalization effect has been increased price competition between regional exchanges and the NYSE, Wood contended. Before decimals, regional exchanges competed with the Big Board based on service or access to local clientele, but rarely on price. Penny pricing has leveled the trading floors somewhat, he said, though regional exchanges still pose no threat to NYSE dominance.

However, if the Securities and Exchange Commission approves a proposal by Archipelago ECN and the Pacific Stock Exchange to create a fully-automated exchange, the NYSE might face increased competition, Wood said.

Warning Sign

For traders, Wood said his research is a warning that decimals are here to stay. "The nature of supplying and demanding liquidity are different once those barriers to competition are removed. It's harder to obtain liquidity now, but you can obtain it at a better price," he said. "If [traders] fail to adjust to that environment, it may cost them more to trade than it did before."