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August 31, 2002

The Fat Cat Days Are Finished: It is time for the buyside toaccept penny trading, argues a guest wr

By Robert A. Wood

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  • The Fat Cat Days Are Finished: It is time for the buyside toaccept penny trading, argues a guest wr

The reduction of the minimum tick size to one penny may be the most controversial rule change in recent years. It is causing the most far-reaching overhaul in institutional trading practices since the introduction of the order handling rules.

These latest changes have had a profound effect on both the Nasdaq and New York Stock Exchange. On the latter, charges of penny jumping have been frequent. But how does penny trading actually improve the quality of the U.S. equity markets?

For the buyside, the biggest complaint is penny jumping on listed stocks. That's quite a change because five years ago the largest number of complaints came from Nasdaq traders. This may be because of the nature of Big Board trading. NYSE specialist firms are driven by profits. They buy and sell stocks that they make markets for. That means they often take long or short positions partly based on their unique knowledge of customer trades. In essence, they are trading against their customers.

The only way for the buyside to defend against penny jumping is to jump first. It can post limit orders, jumping to the head of the line while using ECNs to preserve anonymity in both listed and Nasdaq stocks. Many buyside firms are doing this.

To study the impact of the penny tick size I have examined the top twenty NYSE and Nasdaq stocks as measured by dollar trading volume for the months of August 1996, August 1998 and August 2001. That's when the tick sizes were eighths, teenies and pennies, respectively.

The data for both market centers were provided by the Securities Industry Automation Corporation, or SIAC, which means reporting differences do not allow intermarket comparisons. Quote frequency for the market centers for the top 20 stocks in these months are shown on Table 1. Nasdaq quote frequency in this sample, as shown in the table, grew at 17 times the rate for the NYSE. This suggests that the Nasdaq market has undergone radical structural changes - the order handling rules, the explosive growth of online trading and the growth of ECNs included - changes which have had a decided effect on quoted spreads (See Figure 1).

The distinctive tick size changes are obvious. In the 1/8 regime, about 40% to 60% of Nasdaq and NYSE quotes were at the 1/8. In the teenie category, those percentages were respectively 74% and 98%.

Dealer Market

The tightening of quotes has been far greater in the dealer market with tick size reductions. Yet the most striking revelation of the graph is that both eighth and teenie tick sizes were huge barriers to price competition. Only with a penny tick increase can one see a continuous relationship between spread width and the cumulative percentage of spreads. For example, on Figure 1, note the cumulative distribution for spreads on the Nasdaq market in August 1996 with the eighth tick size increase from 41% to 89% to 95% as spreads increased from 1/8 to 2/8 to 3/8, respectively.

In August 1998, as Nasdaq spreads increased from 1/16 to 2/16 to 3/16 to 4/16, the cumulative percentage increased from 59% to 84% to 91% to 96%, respectively. In each case, the jumps in the cumulative percentage are quite large, particularly for initial jumps.