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July 31, 2003

The Push for a Larger Increment

By Editorial Staff

SEC Chief Economist Larry Harris, speaking on his own behalf, talks to Nina Mehta for Traders Magazine about decimalization, tick size and the option value of limit orders.

Traders Magazine: A lot of institutional traders are reluctant to post limit orders because they get pennied. One result is that there's less depth in the markets. Would increasing the minimum price increment do away with this problem?

Harris: The minimum price increment determines whether what's come to be called the pennying strategy is profitable. Clearly, if it were larger, that strategy would be less profitable. People are very upset now with the stepping in front they're seeing. As a consequence, many people are asking for a larger increment.

Traders Magazine: At the SIA market structure conference in June, you mentioned that any regulatory response ought to consider the option value of limit orders. What did you mean?

Harris: Stepping in front is profitable because it takes option value from standing orders. A standing limit order provides a free option to the market. A buy order is a put that can be exercised by the quickest trader to get to it. A sell order is a call that can be exercised by the first trader to get to it. The pennying strategy extracts the option value of these free orders - option values that traders freely give to the market.

Traders Magazine: Can you give an example?

Harris: Suppose there's a large order at 20 to buy. A fast trader puts in an order to buy at 20.01. When that order fills and the price subsequently rises, he makes a lot of money. If the price falls, he sells to the large trader at a one-penny loss. So the large trader's position is, "I wish I traded when I couldn't and I regret that I traded when I did." That's not good.

Traders Magazine: Is there another solution, besides raising the minimum increment?

Harris: What's happening here is that the large trader is giving up value merely by the fact that he's displaying his order, which we of course want to encourage. There are two ways of dealing with this problem. One way is to make it expensive for people to step in front. The other way is to make it rewarding for people to offer liquidity. Suppose we took market data revenue and distributed it to the exchanges - and ultimately to traders through the exchange rebate programs - in proportion to the times that people are at the best bid or offer. Traders who are at the best bid or offer remain exposed to losses from people using penny strategies but they're rewarded continuously for as long as they're there. With this solution you don't have to have a large tick to deal with the problem.

Traders Magazine: Your idea would be part of a broader series of changes that involve market structure.

Harris: The SEC is considering all issues in market structure and all ideas. I can't comment more than that.

Traders Magazine: A lot of people want to do away with subpenny trading because the price improvement is deemed negligible. What do you think?

Harris: Subpenny trading exacerbates the penny problem and creates more confusion, so it's undesirable from that point of view. On the other hand, many people think that traders should be able to negotiate any price that they want. One advantage of subpenny pricing is it would allow us to incorporate access fees in the quotation montage so that the quote would properly represent the net trade price. But there are other solutions to the access fee problem.