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July 31, 2003

Penny Wise, Pound Foolish?

By Arthur Pacheco

Here are some important points to remember in the debate about decimalization:

1. This is about minimum price variations; not decimals.

Lacking firsthand agency perspective, academics often miss the point about spreads. Most fail to understand that, in an auction environment, spreads are a zero-sum game for investors, whether they be individuals or institutions. Whatever advantage is gained by one investor, is lost by the investor on the other side. In addition, the smaller the minimum price variation, the greater the opportunity for predatory trading, or running ahead. Spreads become relevant only when a dealer provides artificial or immediate liquidity; in which case they serve as the dealer's compensation for convenience as well as the assumption of risk. Spreads serve an economic function identical to fees paid to all dealers of goods and services.

2. Decimalization is here to stay.

We now have a system that makes sense in theory, but is flawed in practice. Sold to the American public as a victory over greedy traders and brokers, most attempts to improve decimalization are now viewed as evidence of Wall Street's unwillingness to take its prescribed medicine. Despite the many unforeseen problems, the system is here to stay. Those who believe decimalization's shortcomings will provide a platform for a return to fractions are misguided.

3. Nickel minimums are (probably) not the answer.

Simplistic solutions including the current proposal to change minimum increments from a penny to a nickel make little sense. Most notably, nickel spreads and other proposed universal remedies based largely on guesswork will appear to the general public as self-serving, knee-jerk responses from the industry. In a recent report, Barbara Roper, the director of investor protection for the Consumer Federation of America, said that although the effects of decimalization should be understood, spreads should not be "artificially widened." Ms. Roper is 100% correct.

4. Tiered increments may be a solution.

One of the underlying flaws of decimalization is the premise that all stocks are identical on any basis; specifically in terms of trading characteristics. It is difficult to argue that widely traded issues such as General Electric or Cisco Systems would require more than a penny or two spread to trade efficiently. There is, however, a strong case to be made for Waste Industries, Excel Technologies and a long list of lower volume stocks, in which quoted prices bear little relation to the true price at which they can be traded. Penny increments in these stocks serve little purpose other than to obscure and discourage dealer liquidity, which is so critical to smoothing erratic trading and price volatility. To address the many trading disparities amongst all stocks, the industry might consider tiered increments. These tiers could vary from a penny to a nickel, for example, based on established criteria such as capitalization, distribution and historical trading characteristics. Assignment of a stock's specific tier could be managed by the New York Stock Exchange and NASD. In my view, this "one size does not fit all" approach is rational, and also likely to be understood and acceptable as a viable and flexible compromise.

5. Much more than pennies are at stake.

At this point, all parties understand that the current system is unacceptable, for legitimate reasons, to significant segments of buyside and sellside market interests. Our job then, is to identify and negotiate a reasonable solution. We are not simply tinkering with brokerage firm profitability or mutual fund performance. More importantly, we are affecting the continued viability of the capital raising process that has fueled the nation's economic engine for the last century and serves as the lifeblood for emerging U.S. companies. The leadership of the securities industry, ideally under the mantle of the Securities Industry Association and the Security Traders Association, must now step up to the plate. If this challenge is not properly addressed - on both a practical and political basis - eventually our franchise may not be worth a plug nickel.

Arthur Pacheco is a senior managing director at Bear Stearns.