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The Counter Reformation

Traders Magazine, October 2003

John A. Byrne Editor

In the history of technology and automation, human worker bees were not replaced by inanimate objects. What occurred was a succession of unprecedented increases in productive capacity, which led to a more mechanical and impersonal society. Some workers were reassigned or cast aside as a burden on society. That's why the latest debate about black box and algorithmic trading, as well as order routing and direct access systems, is fascinating. Once again, the question is whether these new systems will lead to an expansion in worker productivity. Obviously, one answer is yes. For instance, technology will soon permit straight through processing - a flow of data that's mostly untouched by humans - generating productive gains that can be measured by economists. But what about technology fostered in large part by federal regulations? Sure, the latest Nasdaq environment is regarded as fast, dynamic and efficient. However, the productive gains are hard to find in the critical area of institutional trading. In fact, there is growing evidence of a loss of productive capacity. First consider that old chestnut, the order handling rules. Technological advances were necessary preconditions for these rules. These same platforms and cursed rules were a warm up act for decimalization. The result, as we've stated here before, has been a disaster. But you don't have to take my word. Almost a decade after two respected academics produced evidence, purporting to show Nasdaq market makers engaged in price collusion, the pendulum has swung 180 degrees. Indeed, Professor William Christie, having studied the effects of penny pricing, is now a proponent of reforming decimalization policy. He proposes an SEC-sanctioned nickel minimum increment in equity trading. Christie writes in this issue that, "The current tick size of $0.01 exposes all market participants to the decay of price priority. This is a disincentive to submit limit orders of any real size." To be sure, it may seem ironic to hear Christie, the dean and professor of management at Vanderbilt University in Tennessee, propose a sort of new price-fixing model for both the Nasdaq and listed markets. After all, his research in 1994 with Professor Paul Shultz reputedly uncovered this phenomena. However, Christie told me to recall that the order handling rules were introduced in response to evidence that reached this conclusion: Price competition was stymied in the presence of internalization, preferencing arrangements and payment for order flow. The order handling rules, he said, restored truer price competition on Nasdaq, irrespective of the tick size. Some will say it's too late, but Christie still believes there is time to turn back the clock. The benefits of a nickel increment far outweigh the costs. "Advocating a move to a tick size of $0.05 will have the effect of imposing higher than necessary spreads on a small fraction of stocks, while preserving the benefits of price priority and liquidity for all issu

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