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July 31, 2001

Unger Uneasy About Decimals: Will Traders Flout Rules and Regs in Penny Trading?

By Gregory Bresiger

A key regulator says decimals are a mixed blessing for the stock exchanges.

Spreads have been declining so decimals have been a good deal for the individual investor, but their effect on market structure, especially in sub-penny trading - less than a penny - could trigger problems.

That was the assessment of Laura Unger, the acting chairwoman of the Securities and Exchange Commission. Her comments came in a recent speech to the Exchequer Club in Washington, D.C.

She said that the possibility of trading in sub-pennies on a market wide basis raises several difficult issues.

Undermine Rules

"In particular, decimalization may undermine Commission and SRO rules that are dependent on trading quote price changes. If the market is constantly changing as a result of sub-penny trading, priority rules that determine which orders are filled first, rules governing short sales, and rules protecting customer limit orders could be greatly affected," she said.

An example of a potential problem would be the customer limit order rules. On the one hand, specialists and market makers are required to yield to customer orders at a given price. On the other hand, they are allowed to step ahead to trade at a better price than the limit order.

At a penny or less, market makers and specialists can easily profit by trading ahead, making money from their knowledge of limit order flow. However, Unger warns that this kind of trading behavior could have "a domino effect." This could cause public traders to change their trading behavior and strategies in an effort to avoid having their trades executed in pennies.

Step in Front

"More specifically, rather than have their orders stepped in front of by a penny or less, public traders might begin to break their orders up into smaller sizes; they might direct their orders to several different trading venues; or they might have a floor trader quietly work larger-sized orders rather than display such orders," according to Unger. "The result could be increased transaction costs and reduced market liquidity." She noted that when the SEC considered decimals it was based on the idea that trading would be carried out in nickels and dimes, not pennies and less.

"The Commission," she said, "is very concerned about the potential impact sub- penny pricing could have on the efficiency and integrity of the U.S. markets."

Unger's suggestion is that market participants can take a hand in solving the potential problem by deciding on a common minimum price increment. Besides the SEC producing a concept release on the subject, she predicted that the exchanges and Nasdaq would each produce a report this fall.

Pitt's Priorities

Harvey Pitt, the chairman designate of the SEC, also agrees that trading in decimals and sub-pennies should be examined. At his recent Congressional confirmation hearings, he called for "a fact-finding review" by the SEC on the impact of trading stocks in decimals.

Pitt also indicated that he has some of the same questions about Regulation Fair Disclosure (FD) that have been raised by Commissioner Laura Unger. Several securities industry groups have complained that the FD rule is inhibiting the free flow of financial information to analysts and others.

Regulation FD prohibits public companies from selectively disclosing material information.

Advocates of the rule have contended that, prior to its enactment, groups of favored analysts were unfairly allowed to obtain advantages for their firms. But critics contend that material disclosure of information all at once is leading some firms to put a lid on information that was once disclosed. That is the opposite of what FD supporters want, the critics add.