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March 18, 2010

How Low Can You Go?

By James Ramage

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The amount of volume affected is significant. In January, about 2,800 National Market System stocks traded for $10 or less, according to data from Nasdaq OMX. That was 36 percent of all 7,900 NMS stocks. These names accounted for average daily volume of 2.6 billion shares, or 29 percent of the total.

Among the sub-$10 stocks most actively traded are Citigroup, Sirius XM Radio, Dry Ships and E*Trade.


A Smaller Number to Fight Over

By and large, money managers don't trade low-priced names. Still, buyside traders think sub-penny quoting is the wrong move. One head of equities trading for a traditional money manager, who declined to give his name, said the buyside isn't asking for such a move.

"It's just a smaller number to fight over," he said. "It would make stocks seem like they're moving more than they are."

Another head of equity trading at a long-only firm said she didn't even want to move to penny increments from sixteenths. "What is this going to do to spreads and commissions?" she asked. "They're already too low as it is. This is a bad idea."

In January 2001, the New York Stock Exchange started quoting in pennies, down from sixteenths, and from increments of eighths before that. Later, Rule 612 in the SEC's Regulation NMS officially set minimum pricing at a penny. With penny increments, bid-ask spreads shrank.


Leveling the Field

According to the Macquarie research note, the displayed markets have been losing market share to off-board trading over the past two years. In January 2008, 18 percent of equities trading volume was executed off-board. This past January, the number was 31 percent.

Part of the reason for this was because traders in low-priced, high-volume names, such as Citi, have been able to supply price improvement, often by no more than a thousandth of a penny, or simply match the national best bid and offer off-board in dark pools or wherever while avoiding exchange fees, according to the analyst note.

The exchanges see the idea of sub-penny quoting as a way to compete with dark pools more fairly.

"[Sub-penny quoting] gets us on a level playing field," said Brian Hyndman, senior vice president of Nasdaq transaction services. "If you look at the dark pools today, they can quote in finer increments than a penny, and they have a lot of sub-penny executions."

Low-priced stocks are big business at Nasdaq. Roughly 30 percent of its listed stocks trade for $5 or less, Hyndman said, adding that it's 15 percent of the exchange's listed volume. About 56 percent of Nasdaq-listed securities trade for $10 or less. They represent around 35 percent of Nasdaq volume, he added.

Any increase in quoting that a lower trading increment would instigate would benefit Nasdaq's bottom line, the Macquarie report said. Reducing today's trading increment below a penny could lower the overall cost of trading by lowering the implicit costs, the report said. And with lower transaction costs, more trading strategies would become profitable.

"If sub-penny increments help shift 5 percent of market volume from off-exchange to on-exchange," the Macquarie report said, "we would expect around a 7 percent lift in both transaction revenue and consolidated tape revenue, with little incremental costs."