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78–288 PDF 2002

S. HRG. 107–346

THE IMPLEMENTATION AND FUTURE

OF DECIMALIZED MARKETS

HEARING

BEFORE THE

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

ON

THE CURRENT STATUS OF IMPLEMENTATION OF DECIMAL PRICING FOR

SECURITIES, INCLUDING AN ESTIMATION OF COSTS AND BENEFITS

MAY 24, 2001

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PHIL GRAMM, Texas, Chairman

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN ENSIGN, Nevada

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

WAYNE A. ABERNATHY, Staff Director

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

LINDA L. LORD, Chief Counsel

DEAN V. SHAHINIAN, Democratic Counsel

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

MICHAEL B. ENZI, Wyoming, Chairman

CHRISTOPHER J. DODD, Connecticut, Ranking Member

RICHARD C. SHELBY, Alabama

MIKE CRAPO, Idaho

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

JON S. CORZINE, New Jersey

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

KATHERINE MCGUIRE, Subcommittee Staff Director

JOEL OSWALD, Professional Staff Member

(II)

CONTENTS

THURSDAY, MAY 24, 2001

Page

Opening statement of Senator Enzi ....................................................................... 1

Opening statement of Senator Corzine .................................................................. 2

WITNESSES

Laura S. Unger, Acting Chairman, U.S. Securities and Exchange Commission,

Washington, DC ................................................................................................... 2

Prepared statement .......................................................................................... 25

Response to written questions of Senator Enzi .............................................. 56

J. Patrick Campbell, President, Nasdaq, U.S. Markets and Chief Executive

Officer, The Nasdaq Stock Market, Washington, DC ....................................... 7

Prepared statement .......................................................................................... 33

Catherine R. Kinney, Group Executive Vice President, New York Stock Exchange, Washington, DC ..................................................................................... 9

Prepared statement .......................................................................................... 35

Response to written questions of Senator Enzi .............................................. 57

Kenneth D. Pasternak, Chairman and Chief Executive Officer, Knight Trading Group, Inc., Jersey City, NJ ......................................................................... 11

Prepared statement .......................................................................................... 37

Donald D. Kittell, Executive Vice President, Securities Industry Association,

Washington, DC ................................................................................................... 13

Prepared statement .......................................................................................... 41

Peter Jenkins, Managing Director and Head of Global Equity Trading, Zurich

Scudder Investments, New York, NY ................................................................. 14

Prepared statement .......................................................................................... 46

Robert B. Fagenson, Vice Chairman, Van der Moolen Specialist USA, LLC,

New York, NY ...................................................................................................... 16

Prepared statement .......................................................................................... 53

(III)

(1)

THE IMPLEMENTATION AND FUTURE OF

DECIMALIZED MARKETS

THURSDAY, MAY 24, 2001

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, SUBCOMMITTEE ON SECURITIES AND INVESTMENT, Washington, DC.

The Subcommittee met at 10 a.m., in room SD–538 of the Dirksen Senate Office Building, Senator Michael B. Enzi (Chairman of

the Subcommittee) presiding.

OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Let me call the Subcommittee to order.

I am not sure how many people will be attending. There are a

number of things happening in Washington today, virtually at this

moment. But some of us intend to get the business at hand done.

I want to thank Ms. Laura Unger and the other witnesses today

for taking the time to appear before this Subcommittee and share

their views on how decimalization has affected the U.S. securities

market.

While we always compress a little bit to get the main substance

from the testimony, everyone’s complete testimony will appear as

part of the record. When the hearing is over, we will leave the

record open for additional questions for those of my colleagues who

may not make it in at some point during the hearing.

The use of decimal pricing marks a fundamental change to the

way the market participants interact. As with any significant

change, it will take time to fully adjust to the new pricing increments. Most of the reported problems associated with decimalization are not new. Instead, they are old problems that have been

exacerbated and the phraseology has changed a little bit by

decimalization. However, there have been some benefits to the decimal conversion, such as the narrowing of spreads. Additionally, securities are now priced as all other countries’ are priced—and that

is in decimal increments.

I am very confident that the industry will fully adjust to the

decimalization of the securities markets. These challenges will provide the Subcommittee with an opportunity to examine the structure of the market. It calls for reviewing the need of certain rules,

such as the short-sale and trade-through rules. The Subcommittee

will continue to work with the industry to ensure that any adjustments made are in the best interest of investors and the U.S.

capital markets.

2

I look forward to hearing the testimony of everyone today. I appreciate Senator Corzine being here and invite him to move closer

to the front if he would like.

[Laughter.]

I know that got him in trouble once.

[Laughter.]

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. It would be my pleasure, Mr. Chairman.

I want to thank you and Senator Dodd for having this hearing.

This happens to be something that I have spent a little bit of time

with on the other side of table.

I am very much supportive of and know that there are transitional issues here, but one that I think in the long run will serve

investors and the providers of investment services great advantage

over the long run. I am anxious to hear how this is going and look

forward to hearing the testimony.

Senator ENZI. Thank you.

Our first witness today is Ms. Laura Unger, the Acting Chairman of the U.S. Securities and Exchange Commission. We are anxious to hear your testimony. Go ahead and begin.

STATEMENT OF LAURA S. UNGER

ACTING CHAIRMAN

U.S. SECURITIES AND EXCHANGE COMMISSION

Ms. UNGER. Chairman Enzi, and Senator Corzine, thank you

very much for your invitation to speak.

I am pleased to testify today on behalf of the Securities and Exchange Commission about the recent conversion to decimal pricing

and the effects that this change has had on market dynamics and

trading behavior.

As you know, under the leadership of Congress, over the past

year, U.S. markets have successfully moved from pricing shares in

fractions to pricing shares like everything else, as you said, Chairman Enzi, in dollars and cents. The goal of decimalization was to

simplify pricing for investors and to make our markets more competitive internationally. Decimalization was also expected to ultimately reduce trading costs for investors by narrowing quotation

spreads, from the 1⁄16 minimum increment, or 6.25 cents, that was

standard in the fractional environment, to a penny.

While comprehensive analyses of the market effects of

decimalization are not yet available, I am pleased to report that

preliminary reviews by the Commission and the markets indicate

that these goals have been largely met. For example, quotation

spreads in New York Stock Exchange securities narrowed an average of 37 percent, and effective spreads in those securities narrowed about 15 percent. An even more dramatic reduction in

quotation spreads was observed in Nasdaq securities, with spreads

narrowing an average of 50 percent. While it is difficult to estimate

the overall cost savings to investors, the narrowing of spreads

makes it likely that investors entering small orders that are executed at or within the quotes are experiencing reduced trading

costs.

3

Nevertheless, we recognized that the shift to decimal pricing was

a fundamental market structure change that had the potential to

affect the transparency, liquidity, and fairness of the markets. So,

as a result, in June 2,000, the Commission required that the markets carefully phase-in decimal pricing. We also hosted a roundtable last December to solicit views on how the early phases of

decimalization were affecting markets and trading.

In addition, the Commission has asked the markets to conduct

their own studies that would analyze how the conversion was affecting systems capacity, liquidity, and trading behavior, as well as

investor protection. In view of the complexity of these issues, the

Commission has extended the deadline for these markets’ studies

from July 8 to September 10, 2001. In the meantime, we are continuing to work with the markets and market participants to identify any aspects of decimalization that might compromise the fair

and orderly operation of the securities markets.

Today, I would like to focus on how decimalization has affected

market transparency, liquidity, and key investor protections.

As far as market transparency and liquidity are concerned, as

the minimum quoting increment has narrowed to a penny, the

market depth—the number of shares available at the published bid

or offer—has decreased as well. Preliminary estimates indicate that

the New York Stock Exchange quote sizes have been reduced an

average of 60 percent since the decimal conversion, and Nasdaq

quote sizes have been reduced about 68 percent. Some firms and

institutional investors have expressed concerns that the reduction

in quoted market depth may be adversely affecting their ability to

execute large orders. They have indicated that smaller pricing increments have increased the risk that large limit orders will not be

executed. Instead, other market participants will use the information provided by these limit orders to step ahead of the orders for

a penny. This practice could ultimately lead to a reduction in the

amount of liquidity.

In an effort to provide more information about available liquidity,

the Commission accelerated the approval of a New York Stock Exchange rule change in March of this year to disseminate ‘‘depth

indications’’ and ‘‘depth conditions’’ to reflect market interest in a

security below the published bid and above the published offer.

Decimal pricing also raises a number of key investor protection

issues. For example, Commission and market rules protect customer limit orders by providing them with priority over specialist

and market maker proprietary orders at the same price. New York

Stock Exchange and NASD rules require that a specialist or market-maker who wants to ‘‘step ahead’’ of a customer limit order pay

a price that is greater than the limit order by at least the minimum quoting increment. With the conversion to decimals, this

minimum increment is only a penny. This means it will be less

costly for specialists, market makers, and possibly other market

participants to profit from their knowledge of limit order flow by

trading ahead of limit orders for only a penny a share. The fact

that professionals may have an unfair advantage over the little guy

is of concern to the Commission. So, together with the SRO’s, we

are currently gathering information about the operation of these inVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 78288.TXT SBANK4 PsN: SBANK4
4

vestor protection rules in the decimal environment and will consider whether any action is necessary to protect investors.

Finally, I should note that many of the issues raised by decimals

may be exacerbated by the practice of trading at increments of less

than a penny, so-called ‘‘subpenny’’ trading. Subpenny trades by

electronic trading systems and market makers currently account

for only about 4 to 6 percent of trades in Nasdaq securities. But

the Commission intends to further study the impact of subpenny

trading on market transparency and liquidity, as well as investor

protection and market integrity rules.

In summary, while the decimal conversion went smoothly from

an operational standpoint, our work in this area is far from complete. I want to assure you that the Commission will continue to

work with the markets and the securities industry to address potential problems while preserving the benefits of decimalization.

We appreciate the continuing interest of the Subcommittee in

this issue and the role that the Subcommittee has played in helping to ensure a smooth transition to decimals.

Thank you very much.

Senator ENZI. Thank you for what you said and your more extensive testimony.

We are all anxious to see what direction things are going and

what changes might be made. In your testimony, you mentioned

that the Securities and Exchange Commission approved a pilot rule

filed by NASD, specifying certain protections to customer limit orders priced in increments smaller than a penny, or subpennies.

Do you believe there is a trading increment that might be too

small for efficiencies to be realized in the market, particularly in

the listed market? Is there a minimum increment that should

be set?

Ms. UNGER. Well, Mr. Chairman, when we were talking about

the conversion to decimals, the biggest debate was whether it

would be nickels or pennies. At that time no one really contemplated that it would be something smaller than pennies. We are

all very surprised by a conversation about subpennies. But that is

the conversation that we are having.

It is not something that the Commission would like to dictate in

terms of what the appropriate increment should be. We are concerned about some of the issues that the smaller increments will

raise in terms of our regulatory responsibility over the marketplace. And those are, capacity issues and the whole issue of stepping ahead of a customer order, the smaller the increment, the

easier it is, and the more incentive you might have to do it.

It could result in less transparency. If people stop using limit orders because they are not getting filled because they are being

stepped ahead of, then what will happen to transparency in the

market overall?

I do not think we want to dictate to the industry on this issue

and would prefer an industry solution to this problem. But I would

assume it is a problem for them as well.

I am saying, no, we do not want to say what the increments are.

Senator ENZI. Okay. You are not suggesting a change at the

moment.

5

Ms. UNGER. No, I do not think so. But, again, the notion of trading in subpennies raises a number of regulatory issues. And also

flickering quotes and complying with the short-sale rule and a

whole host of other issues. We are expecting to hear from the industry what their recommendations will be. We will have more statistical information about what the exchanges experienced with

decimals trading in the fall, and they will have to submit to us rule

changes by November 10.

Senator ENZI. You mentioned the short-sale rule, and that you

are gathering data and considering changes. I know that the SEC

began its concept release in October 1999, which seems to be an

adequate time for review, even in the light of the relatively new

decimal pricing. What changes are you considering and when do

you expect to have a change of that rule?

Ms. UNGER. With respect to the short-sale rule?

Senator ENZI. Yes.

Ms. UNGER. I think we take the position that the short-sale rule

doesn’t make sense as currently drafted in the decimals environment because of the flickering quote issue. It is too hard to comply

with the rule, and it would be too easy to manipulate.

We are working right now diligently on drafting a rule change,

and we should be ready to release a draft of that soon, and put it

out for comment.

Senator ENZI. Senator Corzine.

Senator CORZINE. Has the concept of block trading been affected

by the decimalization, which gets at much of the depth issue.

Ms. UNGER. Right. I would assume that if people are talking

about an order of a thousand shares being difficult to fill in the

decimals environment—not difficult to fill—but requiring more

transactions to complete, that block trading would be affected by

decimals as well.

I have not heard a lot of anecdotal evidence about that specifically, other than that the institutions seem more concerned about

the limit order issue and not having the orders filled. So I suspect

we will have more information about that, and perhaps the New

York Stock Exchange has something on that.

Senator CORZINE. Right. In the depth indicators, has there been

an embracing of this concept? Is it working? How do you feel? You

commented on it. I am actually curious how that works.

Ms. UNGER. Well, the depth indicator is not very precise at this

point. I think all it shows is that there are a certain number of

shares within a parameter, a price parameter, where there is an

interest. But it does not say how many shares and at what price.

The New York Stock Exchange is refining that a little bit more

and will be working on providing some more specific information as

to the depth of interest.

Senator CORZINE. Refresh me. Nasdaq actually shows the depth

indicators, makes it available, the amount of shares sought or offered at a particular price level.

Ms. UNGER. At a particular price level—at a quote, yes. But I am

not sure that it is to the extent that you are talking about.

And I think the Super-Montage proposal that was approved by

the Commission would probably address a lot of the concerns in

6

terms of showing the depth of the book further down than the

quoted price.

Senator CORZINE. It seems that a number of those kinds of transparency initiatives might correct some of these problems. Are those

being reviewed by the industry or asked to be commented and promoted as concepts, or at least considered as concepts?

Ms. UNGER. So far, the only thing that the Commission has received in terms of a proposed rule by one of the SRO’s is the New

York Stock Exchange’s depth quote proposal. And we approved it

expeditiously on an accelerated basis. So, yes, we would embrace

solutions to this problem of showing the depth in a quote.

Senator CORZINE. Is there anecdotal evidence of charges of stepping ahead, or front-running, by small increments to break up trading patterns?

Ms. UNGER. Yes. As I said in the testimony, there is concern particularly among institutional investors that the limit orders will go

away because of the fact that it is so easy to step ahead of the limit

orders and they are not being filled.

There is a concern, then, if there aren’t limit orders, which the

order handling rules require to be displayed, what will happen to

the transparency in the marketplace? And that is actually a step

backward in terms of enhanced transparency. That is something

that we are definitely concerned about.

Senator CORZINE. And the available liquidity issues, you always

have the risk of a fallacy of composition. We have gone through a

much more turbulent or volatile period in the first 4 or 5 months

of the year. I presume that the overlay of that in conjunction with

the change to decimalization could have different interpretations.

There is different levels of liquidity, I suppose, in so-called bear

markets or highly volatile markets than there would be in straightline moves.

Ms. UNGER. Well, I haven’t heard of any studies tying the volatility of the market to decimals trading. I think it is all Regulation

FD, actually.

And not that, either.

[Laughter.]

Senator CORZINE. I would encourage, though, that when one

looks at whether decimalization is working, and I use it as a generalization, we want to be careful that one doesn’t confuse a different

market environment for the diminishment of liquidity versus the

execution of the decimalization process because it wouldn’t be intuitively obvious whether it was because markets are volatile and

would have been volatile in other environments as well, and you

might have less activity.

Ms. UNGER. Where it really comes into question is if you have

customer orders of, say, over a thousand shares. Then it is hard for

us to ascertain what the cost savings is that decimals provide, because if you have to execute that trade or transaction in multiple

trades, then you have trading costs associated with that. And do

those trading costs then exceed the savings that you have by a narrowed spread brought about by decimals?

Senator CORZINE. Right.

Ms. UNGER. So that is really something that is going to take a

little time to figure out.

7

Senator CORZINE. Thank you, Mr. Chairman.

Senator ENZI. I want to thank you for your testimony and the

questions that you have answered. And I am sure that there will

be more questions.

There are a number of meetings that an hour ago were not

scheduled around the Senate that are happening at the moment to

figure out some changes that are in process. So several of the Members interested in this hearing were not able to be here.

Ms. UNGER. Thank you very much for the opportunity to testify,

Mr. Chairman.

Senator CORZINE. Thank you.

Ms. UNGER. If any of the Members have any follow-up questions

that they would like to submit, of course, we would be happy to answer them in writing.

Senator ENZI. Thank you very much.

Ms. UNGER. Thank you.

Senator ENZI. Our next panel consists of: Mr. J. Patrick Campbell, who is the President of Nasdaq U.S. Markets and the Chief

Operating Officer of The Nasdaq Stock Market, Inc.; Ms. Catherine

R. Kinney, Group Executive Vice President of the New York Stock

Exchange; Mr. Kenneth D. Pasternak, Chairman and Chief Executive Officer, Knight Trading Group, Inc.; Mr. Don Kittell, Executive

Vice President of the Securities Industry Association; Mr. Peter

Jenkins, Managing Director and Head Equity Trader of Zurich

Scudder Investments; and Mr. Robert B. Fagenson, Vice Chairman

of Van der Moolen Specialists USA.

I thank all of you for being here this morning. Again, we have

all of your testimony as part of the record. So if you can summarize

that for us and make your comments in a 5 minute period, we

would appreciate it.

Mr. Campbell.

STATEMENT OF J. PATRICK CAMPBELL

PRESIDENT, NASDAQ, U.S. MARKETS AND

CHIEF OPERATING OFFICER, THE NASDAQ STOCK MARKET

Mr. CAMPBELL. Good morning, Chairman Enzi, Senator Corzine.

I am Pat Campbell, President of Nasdaq U.S. Markets and Chief

Operating Officer of The Nasdaq Stock Market. We welcome this

opportunity to share with you our experience and insights into the

recent conversion to decimal pricing on the Nasdaq market, although it has only been about 7 weeks.

As the world’s largest stock market, ensuring that decimalization

was not disruptive to our investors and the U.S. capital markets

was our primary concern. Crucial to our job as the world’s largest

provider of stock quote information is maintaining the availability,

integrity and accessibility of this data. The estimates of increased

computer demands prior to decimalization made switching a challenging project. One study projected a three-fold increase in

quotation traffic. Decimalization takes the market from 16 price

points per dollar to 100 price points. Due to the hard work of our

highly skilled employees, our member firms, and the Securities and

Exchange Commission, I am glad to report that the decimalization

was accomplished without incident.

8

As the engine of the new economy, Nasdaq is dynamic and is adjusting to changing market realities in order to better serve our

listed companies, member firms, and investors. As you may know,

Nasdaq applied to the Securities and Exchange Commission to become a registered national securities exchange in November of last

year. We expect the SEC to publish our application for public comment in the Federal Register in the immediate future, and we are

hopeful for a speedy approval at the end of the comment period.

This process will facilitate final separation of Nasdaq from the

NASD, lead to our ability to access the capital necessary for our

Exchange to invest in new technology in order to remain a competitor in the world capital markets.

I would now like to share with you our experience with

decimalization. Again, I caution these initial trends are observed

through a fast-track analysis. The three most important points I

wish to share with you today are: First, Nasdaq’s transition from

fractions to decimals was smooth and seamless. To achieve today’s

results in a 5 week period, virtually every computer system within

Nasdaq was changed. A similar effort took place among Nasdaq

broker-dealers. This followed two pilots of decimalization in March

of this year. On April 9, all remaining Nasdaq-listed securities

began to be quoted in decimals. Thus, Nasdaq has successfully

completed the full conversion to decimals in approximately 1

month. Nasdaq has been carefully monitoring the impact of

decimalization both through our on-line surveillance and market

operations group and by gathering and analyzing data for the 2

week period prior to decimalization and the period following

decimalization.

I would like to add that Nasdaq during all of this set a new

share volume record only 7 days after full conversion to decimals

of approximately 3.2 billion shares, and was able to handle that

volume without incident.

The second major observation we have is Nasdaq’s market has

seen a dramatic decrease in spreads. As expected, quoted spreads

declined substantially for most stocks. Quoted spreads on average

decreased by 51 percent. Our most active stocks saw a 71 percent

spread decline. Many of Nasdaq’s well-known and widely held

stocks, such as Cisco, Dell, Intel, Microsoft, and others have now

quoted spreads of one cent. Similarly, effective spreads declined for

all stock groups by an average of 46 percent. This is in addition to

the 30 percent decline seen following the order handling rules and

move to 1⁄16 in 1997.

The third and last observation is that there is no evidence on our

market, to date, that the institutional investors are bearing the

burden of any significant cost-shifting.

We looked at large trades to see if decimalization thinned-out the

market and caused effective spreads for large institutional trades

to increase. Our preliminary evidence is that they did not.

One issue that has caused significant controversy within the industry but not in the Nasdaq market with a shift to decimals was

pennying. On this issue it is useful to recognize that the advantages allowed by Nasdaq’s market structure of a hybrid market

with electronic communications network and competing dealers

have not to date experienced a pennying issue in our market.

9

We also believe competing market makers and ECN’s will continue to provide a market environment that discourages unfortunate behavior. In fact, it is important to note that Nasdaq has been

trading in pennies prior to April 9, 2001. Decimalization for

Nasdaq was an issue of quoting in pennies.

Overall, the implementation has been seamless. It is still a work

in progress. We expect to continue to report our progress to you,

the industry, and to the SEC.

As more time passes, we could see the results change over time.

We plan to continue to conduct our final detailed analysis for all

three phases of decimalization as the SEC is requiring soon. We

are committed to keeping you apprised of any future developments.

Thank you.

Senator ENZI. Ms. Kinney.

STATEMENT OF CATHERINE R. KINNEY

GROUP EXECUTIVE VICE PRESIDENT

NEW YORK STOCK EXCHANGE

Ms. KINNEY. Chairman Enzi and Senator Corzine, my name is

Catherine Kinney and I am a Group Executive Vice President at

the New York Stock Exchange. And I am very pleased to be here

today to relate some of the preliminary results of decimal trading.

Decimalization has been one of the most important occurrences

in our capital markets in the last quarter century. Congress and

the SEC directed this initiative to accomplish significant policy

goals. The NYSE is pleased to have facilitated this conversion process. The benefits of decimal trading have been realized, but the

shift to a minimum price variation, or MPV, of one penny has created some difficulties. The New York Stock Exchange is already

taking steps to remedy some of these detrimental effects. In this

regard, we urge that the MPV be no less than one cent and that

it be established by Congress or the SEC across all markets. Otherwise, the current difficulties will become worse, and the benefits of

decimalization may be jeopardized.

The Exchange is proud that our conversion to decimals was accomplished well ahead of the SEC’s deadline without any systems

or capacity problems. Most of our decimal conversion costs were incurred simultaneously with Y2K system conversions and cost about

$30 million.

The Exchange launched decimal trading with a pilot project of

seven stocks in August 2000. Stocks in the pilot were priced in dollars and cents instead of fractions, and the minimum pricing increment was one penny instead of 1⁄16 of a dollar. The pilot was extended to an additional 57 stocks in September and 94 stocks on

December 4. The entire floor was converted on January 29, 2001,

which was 2 months ahead of the SEC’s deadline of April 9.

We are confident that the conversion to decimal pricing has accomplished important public policy goals. It has certainly brought

the U.S. markets into conformity with the quoting and trading systems that are used around the world. This will help the U.S. equity

markets to expand their foreign listings, make us more competitive

in trading with foreign markets, and certainly will facilitate the

globalization of equity markets.

10

Our preliminary analysis of conversion to decimal pricing indicates that, on balance, the penny increment has been good for some

small retail investors. Stock prices in decimals are certainly more

understandable. Over the last decade, direct share ownership by individual investors has certainly increased, and decimal prices will

encourage this trend by breaking down a barrier to understanding

the markets.

Spreads have been reduced by approximately 37 percent and

price improvement has been significantly increased, particularly for

smaller orders. On the other hand, the one-cent MPV has significantly impacted institutional investors. It is premature to draw any

sweeping conclusions, but we have observed some trends that I

would like to summarize.

Decimal trading has had a number of detrimental impacts on

mutual funds, pension funds, and other institutional investors who

act on behalf of individual investors. These investors, who tend to

trade in large blocks, have experienced reduced depth at the NYSE

quote or the best bid and offer. They have experienced a lack of

transparency of depth or liquidity outside the best bid and offer.

And they have experienced an increased number of execution reports, that is, the number of transactions that are necessary to fill

an order. These market participants are a very important part of

our liquidity.

The impact on institutional investors is an inevitable outgrowth

of the decrease in the minimum price variation from 61⁄4 cents to

one cent. This decrease in the MPV has lowered the transparency

of the market and thus made it harder for institutional investors

to find the right price for liquidity that they require.

Our research to date shows a significant 67 percent decrease in

the number of shares available at the published NYSE quote.

While true liquidity—that is, actual interest from all sources—

available may not have been significantly impaired, there is a significant impairment of transparency.

We have acted to address the transparency concerns of the institutional investor. The Exchange as you have heard this morning,

has initiated two changes to permit dissemination of depth indications and depth quotes in our listed securities. These initiatives are

the first in a series of actions that the Exchange will implement

to improve transparency and communication of market depth in a

decimal trading environment.

Next month, we will also put forward an initiative called Open

Book, and we have certainly expanded the use of hand-held terminals to brokers on our trading floor. In addition, we have formed

an Advisory Committee on Decimalization to review decimal trading at the Exchange and to make recommendations.

We are reviewing Exchange trading rules to ensure that they are

appropriate for the changes that are occurring. We will also be

working with academics to study these issues.

The SEC has requested that we provide a preliminary report by

September 10 on the impact of decimal trading. The SEC has further requested all markets to submit by November 4 proposed rule

changes establishing their individual choice by markets of the minimum pricing increments.

11

We believe an MPV of less than a penny would undermine the

benefits that decimal pricing has brought to the markets, while at

the same time exacerbating the problems that decimal pricing has

caused for institutional investors. In addition, the problems that institutional investors have faced in trading at an MPV of one cent

would be exponentially increased if the markets were permitted to

quote and trade in increments of less than one cent.

I appreciate the opportunity to testify here today, and I would be

pleased to answer any questions.

Senator ENZI. Thank you very much.

Mr. Pasternak.

STATEMENT OF KENNETH D. PASTERNAK

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

KNIGHT TRADING GROUP, INC.

Mr. PASTERNAK. Chairman Enzi, Senator Corzine, good morning.

Thank you for this opportunity to testify today about the impact of

trading in decimals. My name is Kenny Pasternak. I am Chairman,

CEO, and President and Co-Founder of Knight Trading Group, the

world’s largest wholesale market maker for shares of both Nasdaq

and non-Nasdaq equities.

Knight Trading Group supports decimalization. By making stock

prices easier to understand, decimalization encourages market participation and therefore benefits everyone.

The U.S. stock markets recently adopted decimalized trading in

the belief that it would narrow spreads and lead to less costly order

execution. There is no doubt that spreads have fallen. In many instances, order execution has become more costly, not less. My purpose today is to focus this Subcommittee’s attention on this issue.

It is important to know that the introduction of decimalized pricing is not itself responsible for the narrowing of spreads. Rather,

spreads have narrowed as a result of the decision by major market

centers to reduce their minimum price variation—sometimes called

MPV—to a single penny.

Today’s one-penny MPV has reduced price discovery, diminished

liquidity, and increased the level of trading activity required to execute an entire order in many instances. No market participant has

an incentive to quote size, as others can easily coopt that information and trade ahead by as little as one penny. While such problems were once experienced only by institutional investors, they are

now affecting increasing numbers of individual investors as well.

The one-penny MPV is, in many circumstances, too small. In my

view, the most important issue for this Subcommittee’s consideration is how to encourage the markets to arrive at the correct MPV

for a given set of circumstances. This issue is vital to the depth,

liquidity, and overall strength of our markets.

Preliminary data suggests that, even for retail-sized orders, trading outside the spread has increased dramatically. The price discovery process has been impeded because the displayed depth on

Nasdaq has also declined to approximately one-third of what it was

before the transition to trading in decimals began. Meanwhile, we

see that more and more investors feel compelled to break down

their buy and sell orders into smaller lots in order to achieve more

12

control over their executions. Trades generally have increased in

number, but have declined substantially in size.

In addition, the one-penny MPV has occasioned a significant decline in the average number of market participants at the inside

quote. In other words, those who provide enhanced liquidity to the

markets are now committing less capital for the execution of individual investor trades than they did before the one-penny MPV.

Those who proactively provide enhanced liquidity constitute a

large and highly competitive industry that is absolutely essential

to the efficient operation of the markets. They often provide liquidity automatically in amounts considerably larger than the NBBO.

This automatic execution feature expands as the MPV increases

and shrinks as the MPV decreases.

Presently, because of the one-penny MPV, many retail investors

are paying more as the nature of executions changes from fast and

complete to slow and fragmented. During the month of January,

Knight Securities alone provided liquidity above the National Best

Bid and Offer size level in excess of 179 million shares. Without

our enhanced liquidity, we estimate conservatively that investors

would have paid nearly $4 million additional in execution costs.

With the advent of the one-penny MPV, we and our competitors

are providing enhanced liquidity in fewer instances. Whereas, we

previously provided instantaneous, automatic execution at the

NBBO price for any order of up to 2,000 shares, we now reserve

automatic execution for much smaller orders. And in many instances, we do not offer automatic execution no matter how small

the order. This decline in availability of enhanced liquidity for

Nasdaq stocks, coupled with the lower average quoted size, translates into slower and more fragmented executions—and ultimately,

higher costs for individual investors.

In the listed markets, what we are seeing is a pronounced increase in a number of ITS trade-throughs. This means that the investor may actually receive a price dis-improvement.

During the first 6 trading days in February 2001, when decimal

trading was introduced in all listed stocks, Knight Capital Markets

experienced an average of more than 2,500 trade-throughs per day

by NYSE members, a more than four-fold increase over the

predecimalized period.

Before investors can realize the full benefits of decimalization, including cheaper order execution, Congress, the SEC, and the major

market centers must address the negative consequences of narrowing spreads. Some of the blame can be traced to outdated rules

and regulations that were written for an era of fractional pricing

and substantially larger MPV’s.

I have addressed the most important of these issues in my written testimony. The implementation of trading in decimals has

made the markets more accessible to investors, but it has also led

to a number of profound changes that diminish market liquidity,

as well as the speed and efficiency with which investor orders are

being executed.

Only by recognizing and adapting to the changes occurring in the

U.S. markets can we continue to protect the investor, strengthen

market integrity, and maintain the position of leadership that our

market enjoy globally.

13

As this Subcommittee ponders the significant policy issues surrounding decimal pricing, my colleagues and I at Knight would

welcome any opportunity to contribute further to the discussion.

Thank you.

Senator ENZI. Thank you.

Mr. Kittell.

STATEMENT OF DONALD D. KITTELL

EXECUTIVE VICE PRESIDENT

SECURITIES INDUSTRY ASSOCIATION

Mr. KITTELL. Chairman Enzi, Senator Corzine, thank you very

much for the opportunity to speak on behalf of the Securities Industry Association today.

The SIA has worked for over 3 years with securities firms, the

equities and options exchanges and Nasdaq, clearance and settlement organizations, service bureaus, market data vendors, the

SEC, the Department of Justice, the General Accounting Office, a

group of over 500 diverse organizations to convert the U.S. markets

to decimals. We estimate that the conversion cost the industry approximately $1 billion, of which about $600 million we attribute to

increases in capacity.

The operational aspects of the conversion were completed without incident and I would particularly credit the leadership of the

New York Stock Exchange, Nasdaq, as well as my colleagues testifying today, for that successful result.

I have four observations.

The first is that the conversion was a positive step for investors

and for the securities industry. The language of decimals is easier

to understand. The U.S. markets now speak the same language as

markets around the world. The opportunity for competition between market participants has been increased. We eliminated two

particularly aggravating problems—the cloud of suspicion that

hung around fractional trading and the image of Spanish antiquity

with references to pieces of eight both eliminated. SIA has not attempted to put a value on those qualitative benefits.

Second, the conversion has presented a number of challenges.

And I would just like to point out that those challenges were not

caused by decimalization, per se, but by the reduction in the minimum price variation. That reduction in the basic unit of trading

was 84 percent, a 1⁄16 or 61⁄4 cents down to a penny—84 percent.

And that reduction increases the number of trading increments

that market participants can use by more than 6 times. It would

be akin to the U.S. Senate moving from 100 to 625 Senators to deal

with the same set of issues.

When we use the term decimalization, we are really talking

about two subjects—the language of decimals itself and the reduction in the minimum price variation of 84 percent. That reduction

impacts market mechanics by creating more quotes, more trades,

more price movements for traders and systems to handle. Market

screens display the same amount of data, but less information. And

all else being equal, the trading process must work perhaps 15 to

20 percent harder to accommodate the same dollar result.

The smaller trading increment also impacts trading rules, as you

have heard, and these rules impact just about every kind of trade

14

and just about every kind of participant in the market. The increments also impact market making economics by reducing the

spread, which is one of the ways that market makers have traditionally been paid for their services. And that changes the behavior

of market makers, as well as those who trade with them.

Third, market participants will successfully resolve these issues,

in our judgment, through competition, experience, debate, ingenuity, working with the SEC, in the same way that the industry

has successfully resolved difficult issues in the past.

Market mechanics issues are the easiest to resolve, such things

as volume and better display mechanisms. Trading rule adjustments take longer and market-maker behavior issues will take

longer still. We believe that the process of adjustment will be in

front of us for many months.

Finally, the SIA believes that the markets are functioning

smoothly, having accomplished the conversion without incident.

The quality of our markets is as high as it has ever been. Competition has never been healthier.

The industry-wide operations and systems resources have moved

on and are now focusing on reengineering the clearance and settlement system and other projects that will further strengthen the

safety and soundness of the equity markets for all investors.

Thank your for your attention and I would be happy to respond

to questions.

Senator ENZI. Thank you, Mr. Kittell.

Mr. Jenkins.

STATEMENT OF PETER JENKINS, MANAGING DIRECTOR

HEAD OF GLOBAL EQUITY TRADING

ZURICH SCUDDER INVESTMENTS

Mr. JENKINS. Thank you, Mr. Chairman for this opportunity to

testify on decimalization today. My name is Peter Jenkins. I serve

as Managing Director and Head of Equity Trading at Zurich

Scudder Investments. We manage $400 billion for both individuals

and institutions.

I am a trader and I have been a trader for 21 years. I spend a

considerable amount of my personal time promoting market efficiency. Today, my goal for being here is to provide you with practical suggestions to achieve this.

As a preliminary comment, I would like to point out that I

strongly support the move to decimal pricing in the U.S. securities

markets and the trading of securities in minimum increments of

one penny. The move to smaller trading increments reduces the

spread in securities, which will result in benefits to our shareholders. In addition, the implementation of decimalization has enabled the pricing of securities in the United States to conform with

securities markets around the world. Most institutional traders,

such as myself, are continually adjusting to this new trading environment and we are already seeing the development of competitive

products to help us cope with this change.

Some critics have contended that the problems that market participants are facing since the move to decimalization have arisen

solely as a result of that move. I do not believe that is the case.

15

Instead, I would suggest that many of those problems are the result of the underlying structure of the securities markets on which

we trade. Decimalization has simply brought these longstanding

issues to the forefront, thereby highlighting the urgency of addressing several unresolved market structure issues. These include the

need for the display of meaningful depth a of limit orders by specialists and market makers; and the need for priority rules for ordered entered into the securities markets; and the need to address

problems arising from the internalization of orders. I have long advocated that with the move to decimals, we need greater transparency and increased electronic access to the markets.

I should note that most of the difficulties that I have faced since

decimalization have occurred while trading on the New York Stock

Exchange. In contrast, we have had few such problems when trading securities on the Nasdaq Stock Market, due largely to the fact

that electronic communications networks—ECN’s—have offered efficient access and have allowed our traders to deal in smaller increments while at the same time have control over our order flow. But

to the New York Stock Exchange’s credit, they have taken some

bold steps to address these emerging market issues, including the

implementation of the ‘‘Network New York Stock Exchange.’’ However, since the implementation of decimalization on the New York

Stock Exchange, the execution of large orders has actually been

hampered by the reduced transparency of orders on the exchange

limit order book.

The dramatic increase in change of quotes in conjunction with increased instances of market participants stepping ahead of orders

by increments of as little as a penny. The net effect has been for

the institutional trader to lose control of his or her order flow, since

no effective tools exist in the New York Stock Exchange listed market to reach the market efficiently. The ‘‘upstairs’’ trader does not

have the time to negotiate trades as quotes change rapidly. This

lack of control has led the upstairs trader to expose less to the market for fear of being ‘‘front run’’ for a penny. The result is an increasing amount of order flow has left the Exchange and has been

directed to the alternative markets where institutions face less of

a risk of having their orders stepped ahead, further fragmenting

the listed market.

These problems are not due to decimalization. They result from

the fact that the New York Stock Exchange does not provide sufficient protection to the orders that I—and other institutional traders—utilize in trading larger amounts of stock. Today, when an

electronic order is sent to the Exchange via Super Dot, the order

is first exposed to the brokers on the floor who surround the specialists post prior to actually interacting with the Limit Order

book. This technique is called ‘‘an attempt at price improvement.’’

If an electronic order is small, it may in fact receive price improvement. If, on the other hand, the electronic order is large, an institutional order, the specialist may first allow the crowd to interact

with the limit order prior to execution of the trade.

These hidden orders in the ‘‘pockets’’ of the floor brokers gain

standing. When an institution attempts to interact with limit orders on the book, most institutional traders feel this exposure to

the crowd is unnecessary. If the upstairs trader were able to interVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 78288.TXT SBANK4 PsN: SBANK4
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act with the limit order directly without delay, floor brokers might

be compelled to make instantaneous decisions and not use limit orders as options. In order to resolve these problems, institutions

must have facilities for the automatic execution of large orders on

the Exchange and the ability to trade large orders without subjecting these orders to the price improvement mechanisms.

The New York Stock Exchange’s new system, ‘‘Institutional

Xpress,’’ does offer some solutions. But here’s the problems with

Xpress. Orders do not become expressible until it is on the best bid

or offer for a time period of 30 seconds. This should be changed,

to enhance efficiency, there should be no time limit. Institutional

Xpress also requires that an order be at least 25,000 shares in

size—this number is too high. Institutional Xpress should be able

to react through the offer to get to the available liquidity pool.

These large orders eligible for execution in that system should

not be permitted to be represented by specialists to the crowd on

the floor of the Exchange. The New York Stock Exchange has the

opportunity to promote the placement of limit orders on the book

by providing protection for, and rewarding the placement of, those

orders and attracting order flow. These improvements that I suggest will serve to increase the depth and liquidity of the market.

Greater transparency, along with greater liquidity, will benefit our

investors to enabling them to get a more effective execution.

In closing, I want to stress that I have worked with the New

York Stock Exchange and other exchanges, as well as the Investment Company Institute directly for many years to voice my opinions, along with those of my competitors, on how best to provide

institutions the liquidity we need to perform effectively on behalf

of our clients’ portfolios. These changes I suggest do not pose a

threat to the New York Stock Exchange. In fact, these enhancements will offer the ability for both institutions and retail participants to transact more efficiently and at the best price.

Thank you.

Senator ENZI. Thank you.

Mr. Fagenson.

STATEMENT OF ROBERT B. FAGENSON

VICE CHAIRMAN, VAN DER MOOLEN SPECIALISTS USA, LLC

VICE CHAIRMAN, THE SPECIALIST ASSOCIATION OF THE NYSE

Mr. FAGENSON. Chairman Enzi, thank you for having me here

today. I am Vice Chairman of Van der Moolen Specialists, one of

the largest specialist firms on the floor of the Stock Exchange. I am

also Vice Chairman of the Stock Exchange Specialist Association.

So I am really here today representing the 480 men and women

who are the specialists who do make the markets on the floor of

the New York Stock Exchange.

In 1997, the House introduced a bill called The Common Cents

Pricing Act, and I had the opportunity to testify before the Subcommittee on Finance and Hazardous Materials, known as ‘‘cash

and trash.’’ We made several points there and, quite frankly, they

have all come true.

Reduced minimum trading increments from 121⁄2 cents to 61⁄4

cents to a penny, are really down more than 90 percent now, and

they are easier to understand. We said that this would reduce payVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 78288.TXT SBANK4 PsN: SBANK4
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ment for order flow, which distorts the markets, where brokers

send their orders to dealers who pay them for them, and perhaps,

to a certain extent, ignore their fiduciary responsibility. This has

been reduced, but it hasn’t been eliminated.

We felt this would hurt the regionals’ ability to compete and, at

this point, we think it has. And we fear that the Philadelphia Stock

Exchange’s equity business may, in fact, be in jeopardy.

This would certainly create the ability for market participants to

price improve or step ahead, depending upon the terminology you

would use, for one penny. That certainly has happened, and also

that the market would get cluttered with a tremendous number of

meaningless flashing quotes and liquidity would be harder to find,

although it was still there.

Now all this has come to pass and it was not because we are

geniuses and we had some crystal ball. But we do do this for a living and after 30 years on the floor, I can tell you that none of this

was unexpected.

We suffered a shock to the system, despite the fact that, technically, we were all prepared and the SEC made sure that we were,

and the SRO’s did a good job.

It is the equivalent of traveling the same road to work every day

for 30 years and it was 10 miles long, and there were eight traffic

lights. And suddenly, one day, there were 16. It would be a bit

more difficult, but it wouldn’t be a tremendously noticeable change.

Then one day, you woke up and there were a hundred lights on

that same 10 mile stretch. Some were green, some were red, and

some were yellow. So you had to stop some places and some places

you did not, and every day, it changed.

You knew the road really well and you were going to get to the

other end, and it was a pretty safe travel. But it probably took a

little longer, and the end and the time it would take was probably

somewhat more obscured. And this, despite the fact that you were

dealing in increments that were given to greater clarity.

The participants all had to relearn how to do certain things. We

had to develop new systems and the New York Stock Exchange has

been moving aggressively to do that.

What Cathy Kinney mentioned in terms of depth indications,

depth conditions, the use of enhanced hand-held electronic devices

to transmit information, and a look at the book that would allow

investors to see a hundred price points, are certainly things that

are going to move toward making this transition a lot smoother.

It is almost like the equivalent of installing radar or sonar on

your car as you traverse that road. It just lets you see out a little

bit further so that you know exactly what is coming up.

We are a lot busier on the floor. There are a tremendous number

of quotes. A lot more trades per order. A 500- or a 1,000-share

order that used to get executed in one transaction, now may take

two or three. These are just the realities that we have to deal with.

Spreads are narrower, clearly, but the sizes at those reduced

spreads are smaller.

There are many inaccessible quotes that create tremendous frustrations, not just for Peter, but for all investors, large and small.

I do not want you to confuse spreads with liquidity. Spreads have

narrowed, but liquidity most likely is pretty much the same. It just

18

is somewhat more obscured and a little bit harder to access. But

we are working on that.

Price discovery certainly has slowed. It is almost the equivalent of trying to buy a house and negotiating in $100 increments. That

may take a little bit longer than the way it is normally done.

The ability to narrow quotes to a penny caused a tremendous upheaval. The phrase pennying was coined. Suddenly, there was a

tremendous amount of finger-pointing. The specialists were blamed

for all of it. We were unprepared for the result.

But the statistics are proving that it is the professional traders,

day traders, and floor brokers representing financial institutions

that are in fact taking advantage of this ability to get a better price

for their customer in increments as small as a penny.

Yesterday, I learned of a new trading program that was developed to watch for quotes that are somewhat larger than average

and automatically enter orders for a thousand or two thousand

shares, a penny below or a penny above, just to try and take advantage of a perceived opportunity. But brokers are learning, both

upstairs, off the floor, and downstairs, how to accommodate.

If a market in Black Hills Power were 57 bid, offered at 57 and

25 cents, and that became narrowed to 57.10 bid and 57.15 offered,

limit orders are now being entered to buy at prices higher than

that lower offer, to bid through it and access the liquidity that is

hidden above, and sell orders lower than the posted bid to access

those buy orders below the posted bid, down to the point where

that seller is willing to sell. Brokers on the floor are being given

greater discretion, so they can access liquidity where they find it,

and not having to run back to the phone every 2 minutes to ask

for additional instructions.

Mr. Chairman, we have the most powerful liquidity pool the

world has ever known and it is intact and it is working just fine.

We are still the envy of the world. We have increased the clarity

and we are moving to solve our problems. But let us not forget why

we did it.

We did it to create a system that was more customer-friendly.

With trading increments reduced 90 percent and in dollars and

cents, we are essentially there. But there is a great threat that

looms. We could lose the very clarity that we have all fought so

hard to try and create.

If we permit subpenny trading to proliferate, trading in hundredths of a penny, in thousandths of a penny, we will destroy the

ability to access liquidity. We went from saying that 10.125 was

difficult to understand and 10.0625 is more difficult. So we said

10.05 sounds fine. Are we now to say that we bought something at

10.0237, is that better? When was the last time you walked into

a supermarket and asked for 1.537 pounds of ham?

We have created a system that is efficient, effective, and understandable. Do we really want to create the equivalent of an impressionist art auction where bids go up a hundred dollars at a time?

The buyers and sellers would be dead before the auction is over.

Public confidence is hard to build and easy to destroy. We have to

continue to design our systems for investors, not for practitioners.

Just because we can do it, doesn’t mean we ought to do it. And

our industry, sometimes has acted in the reverse. As we look at

19

rules such as the short-selling rule, let us take a hard look. But

let us not forget that issuers and the public like some of these and

before we change them, let us make sure we get their opinions.

Subpenny trading can undo all the good we have accomplished.

We call on you to go past what the SEC would suggest, which is

study of this issue, and pass legislation that prevents the minimum

increment nationally from moving below a penny unless we all decide that it is the right thing to do.

The road to work may take a little bit longer to get there under

certain circumstances, but let us not risk creating a gridlock that

destroys the system we have worked so hard to build that we cannot undo.

Thank you.

Senator ENZI. Thank you very much.

I want to thank all of you for your excellent testimony, not only

the great job you did of convincing and summarizing here, but also

the more extensive testimony. From my standpoint, I appreciate

the way that you kept it simple and clear. Many of us do not have

the depth of understanding or experience that you have acquired

in your years of dealing with this. And, of course, one of our tasks,

is to take what you told us and put it in terms that our constituents can understand, who are often confused and sometimes upset

when they are talking to us. So I do appreciate your effort and the

tremendous job that you did.

To start the questioning, do any of you who spoke at the beginning have anything that you would like to comment on as a result

of what has been said? And then those who testified later can say

something about what they are saying now. Are there any additional comments based on the additional testimony?

[No response.]

I saw some note-taking up there at the desk, so I thought there

might be.

One of the reasons that we are holding this hearing today is

because there have been numerous complaints about orders, particularly large orders, being stepped ahead by specialists and floor

brokers. I do realize that there is the flip side to that, where there

is some receiving of price improvement. Can you tell me what this

effect is going to have on the small investor. Anyone?

Mr. FAGENSON. Well, the small investor who is buying in 100-,

200-, 300-share lots has probably benefited the most from the

change to decimal pricing because those small quotes that are created either by computer programs or other retail orders are usually

in the size that the smaller investor is buying or selling. And at

that narrower spread, they are probably saving some money.

The greater frustration comes in for institutional investors such

as Peter Jenkins, who has to deal in 100,000-, 200,000-, and

500,000-share lots, and how do they find that liquidity? And that

has become somewhat more of a task.

So the small investor probably is having a better time and is

probably reaping the greatest benefit. But once you get above that

200- or 300-share lot, it becomes a lot less clear. And in fact, they

may be paying more in certain circumstances.

Mr. JENKINS. I would add one thing. Zurich Scudder manages

mutual funds and we have to remember that we represent thouVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 78288.TXT SBANK4 PsN: SBANK4
20

sands of individual retail mutual fund shareholders. My costs, if

they are increasing, are affecting the retail. We need not forget

that. It is not only the individual that comes direct to the

Exchanges, the retail broker, but also the mutual fund shareholders as well.

Senator ENZI. Excellent point. Anyone else?

Mr. Pasternak.

Mr. PASTERNAK. I think, just to take you back in history to illustrate, about 5 years ago, an individual investor who was trading

on-line, let us say at the birth of the Internet in 1995, he could buy

5,000 shares of virtually any Nasdaq stock, for instance, at the

NBBO—the National Best Bid and Offer—the spread was generally

an eighth or better or wider, for about $40.

By about 1998, 1999, the price of that transaction had gone down

to about $9 or $10 on the commission side. But the auto-exsize had

gone down to 2,000.

Just to show you the tenuous balance between that proposition,

over 95 percent of all orders were still automatically executing.

And generally speaking, depending on how you define individual

investor orders, a large proportion—I do not have a stat right

here—but I would say at least 90 percent of all investors, individual investors, units of trading, are 2,000 shares or less meaning

the marketplace was providing liquidity at the national best bid

and offer the vast majority of the time. Today, under decimal pricing, that is occurring in our environment less than 50 percent of

the time.

I think Mr. Jenkins made a statement about the NBBO having

some relevance in two cases. In the case, to make an assessment

of how to proceed with a strategy to trade. And second, from a

small individual investor. I would define it as 2,000 shares or less.

Should there be a sense, a high sense of confidence that I can

buy or sell, and even lower that to 1,000 shares of virtually any security in the United States at a price that I am seeing? If that

sense of confidence is not there, then in fact what use is a pricing

stream that includes a National Best Bid and Offer if most Americans cannot effect the transaction at that price?

Senator ENZI. Mr. Campbell.

Mr. CAMPBELL. It is clear that in terms of the display depth on

Nasdaq is about one-third of what it was in a 16th environment.

The real question is, moving from 61⁄4 pennies and then putting

it in comparison to penny increments as opposed to 16th, is the

depth through that roughly the equivalent of what it was when it

was in the 16th increment? Having been at this for 7 weeks, and

having our display depth about a third of what it was prior in a

fraction environment, I think right now, it is still premature for us

to be able to come out and say, okay, this is exactly what is happening, and watching it migrate to some point in time where we

really have statistical evidence as opposed to anecdotal.

Senator ENZI. Mr. Fagenson.

Mr. FAGENSON. Mr. Chairman, historically, whenever we have

increased the flow of information to investors, the market has

grown. Whenever we have enhanced the quality of the information,

the market has grown.

21

The challenge is to make sure that we can have investors see not

just the NBBO, but where liquidity resides. And we are moving in

that direction by opening up the specialist book and by offering

these depth indicators.

That is really one of the keys. And in terms of Institutional

Xpress, a system that Peter spent some time explaining, I would

only say, if you understand it now, you ought to come to the New

York Stock Exchange and take over because it is a complex system,

and I was one of the people who helped design it and I still find

it complex. But we did design it and we continue to enhance it, and

we will, to give just the type of institutional access that Peter is

talking about. And hopefully, over time, it will prove to be a system

that works well. We want all investors, small and large, to have

the best information. And the systems that provide that will continue to serve to expand the market.

Ms. KINNEY. Chairman Enzi, I think one of the issues that we

raised in our testimony and one that is important to the Exchange

is this issue of ensuring that both Congress and the SEC look at

the issue of the MPV and not allow the minimum price variation

to go below a penny. I think a number of the issues that have been

raised here, whether it is reduced depth or whether it is reduced

transparency, will all be exacerbated if the markets go below one

penny as the minimum price variation.

We would all agree here that individual investors who are buying

500 shares of IBM, or those that are buying 500 shares of Microsoft, are certainly getting better prices, when you look at what is

driving the markets and the institutional interest in the markets,

as well as individuals who are buying larger numbers of shares,

you have to be concerned about some of the impacts that you have

seen. And they certainly are impacts that we have seen before.

A study has just come out by two economists looking back over

the experience of moving from eighths to sixteenths. And they have

concluded that simply having spreads narrow is not a good indicator of cost of execution. We just draw that to your attention as

well and try to balance this issue across a variety of investors who

are involved in the markets.

Senator ENZI. Thank you.

One of the things that Congress does is step in the middle of

things occasionally. The purpose of this hearing was not to do that.

It was to get some very basic information on a system that changed

relatively recently—very recently—to see if any problems were

cropping up yet that we would begin to hear about. Of course, we

would hope that you, in cooperation with the SEC, would make the

necessary changes and it wouldn’t ever become a legislative responsibility.

In regard to the SEC, does the decimal implementation change

the necessity of certain regulations, such as the short-sale rule or

the trade-through rule? Are there things pending there now that do

not need to be done and some that do need to be done that maybe

are not being considered?

Mr. Fagenson.

Mr. FAGENSON. I think we have to make sure that we do not

think about every stock trading the same way. Stocks trade difVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 78288.TXT SBANK4 PsN: SBANK4
22

ferently. Your hundred most active stocks are going to trade far differently than your hundred least active stocks.

There are all sorts of variations in the middle. And while eliminating the short-sale rule in your top one hundred stocks might

crate additional liquidity, it might create havoc and market manipulation in less liquid stocks. So this is really an issue that I think

requires tremendous study.

If you ask issuers and you ask small customers whether they

take comfort in a rule such as the short-sale rule, I think, universally, they would probably say yes. But before we upset that delicate balance, I think we have to make sure that the perceived benefit is really there before we destroy this element of public confidence that I think is an important piece of the market framework.

Senator ENZI. Mr. Campbell.

Mr. CAMPBELL. Mr. Chairman, we have submitted rules to reflect

the new structure and the trading environment that we are in to

address the changes brought about by decimalization.

My only concern is that the SEC opines on the short-sale rule

prior to an adequate time to evaluate as we are doing our new

experience with about 7 weeks of history behind us in a decimal

environment. Our concern is that it is well thought out, that it is

adequately discussed, and the empirical evidence is there to be able

to make an important judgment call as we start modifying the

rules in a new market environment.

I do agree that there are some very important attributes of shortsale rule that are very important to a lot of people.

Our only concern is that we have the right debate with the right

information at the appropriate time when the empirical evidence is

available, and it is not today.

Senator ENZI. Anyone else wish to comment on that?

[No response.]

The foreign markets have been decimalized for a longer time

than we have, they have probably been dealing with some of the

problems that we have discussed, such as the shrinking limit orders and stepping in front. How are they handling it? Or are they

worrying about it at all?

Mr. Jenkins.

Mr. JENKINS. I think in the foreign markets, they have stressed

time and price priority and connectivity. And I think that is the

way they are dealing with a lot of these problems.

Clearly, they have their problems as well. But priority of order

placement is important, or a little bit more important, in the international markets.

Mr. KITTELL. Also, in the case of some international markets, the

minimum price variation varies by the price of the stock.

So that a $100 stock would have a higher minimum price variation than a $10 stock. And there will be a schedule of four or five

minimum price variations up and down the price scale.

We have that in the United States here in the case of options

trading, where the options priced below $3 trade at the moment in

5 cent increments, and over $3 trade in 10 cent increments.

Mr. PASTERNAK. Just two comments. We do have operations in

Europe and Japan and we are active in those markets. We do have

23

a perspective—it is a real-time perspective. You could make a few

observations about the foreign markets.

First is that the individual investor is not as far along as he is

in the United States. So there is still a very heavily institutional

market that is in almost every market in the world.

Second, that their markets are behind our markets and we are

the envy of every market in the world when it comes to liquidity,

price discovery, and what I call liquidity provider participation.

And finding that sweet spot between rewarding price discovery—

I think Mr. Jenkins has an excellent point about incentivizing and

eliminating people from coopting your information and rewarding

you properly.

Markets have to take that head on and find a balance between

that and people who are bringing liquidity, capital and expertise to

the market, liquidating both block trades for institutions, providing

knowledge for institutions, and liquidating individual investor

transactions. The foreign markets have not reconciled that and

there is no culture whatsoever of capital commitment and immediacy for individual investors in virtually every market in the

world, except for ours. As we look forward, we should protect what

we have and keep refining it, but not to think that our markets are

second to each, but certainly respect innovation, even if it comes

from around the world.

Mr. FAGENSON. We make markets in Germany, Great Britain,

Amsterdam and here in the States. We were the largest specialist

on the Amsterdam Stock Exchange for many, many years. We still

are, although they are doing away with the specialist system.

These markets are far smaller than we are. As Ken just said, they

take absolutely no notice or concern for the individual investor.

I mean, the big bang in London was the sound of the small investor getting whacked over the head. They bifurcated that market

into wholesale and retail so that they could hide what they were

doing in size transactions and in not any way demonstrate what

the true price was. Price discovery went on behind closed doors. So

they have been doing it longer, but that is just made them more

expert at hiding things.

Senator ENZI. Mr. Campbell.

Mr. CAMPBELL. Mr. Chairman, I think the one thing that everybody at this panel has really pushed very hard in everything the

capital markets, the United States, does today is transparency.

Most foreign markets have solved their decimal issues by lack of

transparency. And as we continue to balance as much information

that we can provide for the benefit of the investor, that is part of

what we are all trying to do in the most sincere way we know how.

Most foreign markets have gone the other way. You cannot see

what the problems are because they do not allow you to.

Senator ENZI. Anyone else?

[No response.]

I am glad that I asked that last question because it is not often

in the Banking Committee when we are dealing with securities or

accounting issues and those sorts of things, that you get that feeling of patriotism, and how great it is in the United States.

[Laughter.]

24

Every one of you reflected how we have it better in the United

States. Of course, that is what this Committee wants to make sure

happens, that that same thing continues as we become kind of a

clearinghouse for complaints, mostly from constituents.

I think the view of the Committee is that the decimalization has

gone well and that life is good in the United States. Some of the

things that you mentioned may be more of an effect of the economy

than the decimalization process. And we want to keep a careful eye

on that.

I do have a series of questions for each of you. But I will submit

those to you and would appreciate your answers. And then, when

I get the answers, I will circulate both the questions and the answers to my colleagues. And we will be doing some summaries of

what you said and emphasizing those a little bit, too. Of course,

they will be from my perspective because I am the one here.

[Laughter.]

So I do appreciate your participation today and all of your help.

We will be calling on you again. Thank you very much.

Ms. KINNEY. Thank you very much.

Mr. CAMPBELL. Thank you.

Mr. JENKINS. Thank you very much.

Senator ENZI. The hearing is adjourned.

[Whereupon, at 11:20 a.m., the hearing was adjourned.]

[Prepared statements and response to written questions for the

record follow:]

25

1See Securities Exchange Act Release No. 42914 (June 8, 2000), 65 FR 38010 (June 19, 2000).

2The effective spread measures the cost of trading by comparing the execution price of a trade

with the current mid-point of the quoted spread. Since trades sometimes occur at prices that

are better than the posted quotes, the effective spread measure captures this ‘‘improved pricing.’’

PREPARED STATEMENT OF LAURA S. UNGER

ACTING CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

MAY 24, 2001

Chairman Enzi, Ranking Member Dodd, and Members of the Subcommittee:

I am pleased to testify today on behalf of the Securities and Exchange Commission (‘‘Commission’’ or ‘‘SEC’’) concerning the recent conversion of quotations in equity securities and options from fractional to decimal pricing and the effects that

this change has had on market dynamics and trading behavior. I would particularly

like to address not only the benefits of decimalization, but also some aspects of this

historic change that could affect the transparency, liquidity, and fairness of our

markets.

I. Introduction

As you know, under Congress’ leadership, over the past year the U.S. markets

have moved from pricing shares in fractions to pricing shares in dollars and cents— the same pricing used in virtually all other aspects of the economy. The goal of

decimalization was viewed as necessary to simplify pricing for investors and to

make our markets more competitive internationally. Many proponents of

decimalization also hoped that decimal prices would ultimately reduce trading costs

for investors by, among other things, permitting quotation spreads (the difference

between the highest bid quotation and the lowest offer quotation) to narrow from

the 1⁄16 minimum increment that was standard in the fractional environment.

Over the last year, the Commission has sought to ensure that the conversion to

decimal pricing was accomplished in as rapid but orderly a manner as possible. On

June 8, 2000, we issued an order directing the securities exchanges and the Nasdaq

Stock Market (‘‘Nasdaq’’) to phase-in decimal pricing beginning no later than September 5, 2000, and ending no later than April 9, 2001.1 As a result of the careful

planning, preparation, and coordination among regulators, the markets, clearing

agencies, vendors, and the securities industry, I am able to report that the phasingin of decimal pricing was completed on schedule and without significant operational

problems or trading disruptions.

While comprehensive analyses of the market effects of decimalization are not yet

available, preliminary reviews by the Commission’s Office of Economic Analysis

(‘‘OEA’’) and Nasdaq indicate that at least some of the anticipated benefits of

decimalization, such as the significant narrowing of quotation spreads, are already

evident. For example, OEA estimates that, from December 2000 to March 2001,

quotation spreads in securities listed on the New York Stock Exchange (‘‘NYSE’’)

narrowed an average of 37 percent, and effective spreads narrowed 15 percent.2 An

even more dramatic reduction in quotation spreads was observed in Nasdaq securities, with spreads narrowing an average of 50 percent following decimalization, and

effective spreads narrowing almost as much. While it is difficult, at this time, to formulate accurate estimates of the extent to which investors may have benefited from

decimalization, the overall narrowing of spreads makes it likely that investors entering small orders that are executed at or within the quotes have experienced reduced

trading costs.

In addition, preliminary studies by Nasdaq indicate that, despite the concerns

previously raised by some market commentators, decimal pricing has not expanded

quotation traffic or exacerbated capacity demands to the extent anticipated. Although there is some evidence that the number of quotation updates has increased,

the fears that decimalized quotes would cause reporting backlogs and outages appear to have been unfounded.

Nevertheless, the Commission has long recognized that the shift from fractional

to decimal prices had the potential to influence market dynamics and trading behavior in ways that could affect the transparency, liquidity, and fairness of the markets.

When ordering the decimal conversion last June, therefore, the Commission required the markets to carefully phase-in this process in order to provide regulators

and market participants opportunities to observe how decimalization worked in

practice. The Commission hosted a roundtable on December 11, 2000 to solicit viewpoints on how the early phases of decimalization were affecting markets and trading. Moreover, our June 8, 2000 decimals order required the markets to conduct

their own studies within a few months of the full implementation of decimal pricing

on April 9, 2001 that would analyze how the conversion had affected systems capacVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6621 78288.TXT SBANK4 PsN: SBANK4
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3The difficulties inherent in conducting useful analyses of the effects of decimalization in such

a short time frame were also discussed in a letter from the American Stock Exchange (‘‘Amex’’)

requesting an extension of the June 8, 2001 deadline for decimalization studies. See letter to

Annette Nazareth, Director, Division of Market Regulation, from Peter Quick, Amex President,

dated May 9, 2001. The Commission has decided to extend the study deadline not only for the

Amex, but also for the other securities exchanges and the NASD. 4See letter to Richard A. Grasso, Chairman, New York Stock Exchange, Inc., from Craig S.

Tyle, General Counsel, Investment Company Institute, dated March 11, 2001. 5See Securities Exchange Act Release No. 44084 (March 16, 2001), 66 FR 16307 (March 23,

2001) (NYSE Rule 60). The Commission’s Advisory Committee on Market Information is also

considering a range of market transparency issues.

ity, liquidity, and trading behavior. In view of the complexity of some of the issues

that have been raised concerning decimal pricing, the Commission has extended the

deadline for the markets’ studies to September 10, 2001.3 In the meantime, we are

continuing to work with the markets and market participants to identify any aspects of decimalization that might compromise the fair and orderly operation of the

securities markets.

Today, I would like to focus on how decimalization has affected market transparency and liquidity, as well as key investor protection and market integrity rules

of the Commission and the self-regulatory organizations (‘‘SRO’s’’).

II. Effects on Market Transparency and Liquidity

Market transparency—the dissemination of meaningful quote and trade information—assists investors in making informed order entry decisions and enables

broker-dealers to meet their best execution duties for their customer orders. Moreover, market transparency plays an essential role in linking dispersed markets and

improving the price discovery, fairness, competitiveness, and attractiveness of U.S

markets. Currently, the quotes and trade reports from all registered exchanges and

Nasdaq are published on a consolidated basis to vendors, brokers, and customers

worldwide.

Decimal pricing presumably has enhanced the ability of investors to understand

the consolidated quotations of competing market centers. Investors can now easily

compare prices to buy and sell stocks in dollars and cents without having to deal

with prices in fractions. Nevertheless, we recognize that, as the minimum quoting

increment has narrowed to a penny, the market depth at any particular price level

(that is, the number of shares available at the published bid or offer) has decreased

as well. For example, OEA has estimated that quote sizes in NYSE-listed securities

have been reduced an average of 60 percent since the conversion to decimals and

preliminary analyses of Nasdaq securities show a 68 percent reduction in quote

sizes. Some firms and institutional investors also have expressed concerns that the

reduction in quoted market depth may be adversely affecting their ability to execute

large orders.4 In particular, market participants have indicated that smaller trading

and quoting increments have increased the risk of displaying limit orders, particularly larger limit orders, leading to a reduction in the amount of liquidity provided

by such orders. In an effort to provide more information about available liquidity,

the NYSE recently proposed, and the Commission approved on an accelerated basis,

a rule to disseminate ‘‘depth indications’’ and ‘‘depth conditions’’ to reflect market

interest in a security below the published bid and above the published offer.5

We recognize, however, that these measures alone are unlikely to address market

participants’ liquidity concerns in a decimal environment. We have asked the markets to evaluate these concerns in their reports to the Commission, and we will

work with the markets and the securities industry to identify and address any negative effects from decimalization on overall market transparency and liquidity.

III. Investor Protection and Market Integrity

We recognize that decimal pricing also raises a number of issues regarding vital

investor protection and market integrity rules of the Commission and the SROs that

depend on price changes or differentials. I will briefly mention two examples.

Customer Limit Order Protection Rules

Investors use two main types of orders to buy securities: market orders and limit

orders. When a customer uses a market order, a broker will execute the order in

the market at the best price available. When a customer uses a limit order, a broker

is required to obtain an execution at the limit price or better. By submitting a limit

order, the customer competes for a better price than the market is offering, or limits

the price that the investor will accept. As a result, limit orders provide liquidity to

those who demand immediate execution. Limit orders are a very important source

of price information and market liquidity in the equity markets. When customers

27

6 Exchange Act Rule 11a1–I (T) requires Exchange members to grant priority to any bid or

offer at the same price for the account of a person who is not a member. NYSE Rule 92(b) prohibits NYSE members from trading for their own account at the same price as an unexecuted

customer limit order. The NASD’s Manning Rule similarly requires the execution of a customer

limit order upon the execution of a proprietary trade at a price that would satisfy the customer

limit order. See NASD IM–2110–2—Trading Ahead of Customer Limit Order. 7 It should be noted that when a specialist or market maker ‘‘steps ahead’’ of a limit order,

it provides ‘‘price improvement’’ to the execution on the contra side of the trade. For example,

assume that a customer limit order is sent to a specialist or market maker to buy 100 shares

of XYZ stock at $10 per share for a total of $1,000. The specialist or market maker may decide

to ‘‘step-ahead’’ of the customer limit order and trade with a customer order to sell the security.

While the customer buy order would remain unfilled in this situation, the customer sell order

would receive a price from the specialist or market maker that is better than it would have received from an execution with the customer buy order. 8 NYSE Rule 92(b) establishes a defacto ‘‘stepping-ahead’’ increment based on the NYSE’s minimum trading and quoting increment. That increment is currently a penny for most securities.

The NASD’s Manning Interpretation requires market makers who want to trade ahead of cus- tomer limit orders to trade at a price $0.01 better than the customer limit order priced at or

better than the inside market. For customer limit orders priced outside the inside market, a

market maker must trade at a price at least equal to the next superior minimum quotation increment. See Securities Exchange Act Release No. 44165 (April 6, 2001) 66 FR 19268 (order approving Nasdaq proposed rule change to the Manning Interpretation adopting a $0.01 price

improvement standard for securities quoting in decimals.) 9For example, assume that a public limit order is entered to buy 100 shares of XYZ stock at $10 per share for a total of $1,000. Under fractions, with a minimum price increment of 1⁄16

a specialist or market maker could trade ahead of the customer buy order by executing at

$101⁄16 per share, for a total of $1,006.25. With the decimals minimum price increment of a

penny, it is possible that the specialist or market maker could ‘‘step-ahead’’ of the customer

order by paying $10.01 per share for a total cost of $1,001 to buy 100 shares, an 84 percent

reduction in the ‘‘stepping-ahead’’ cost. 10See Rule 3b–3 under the Exchange Act, 17 CFR 240.3b–3.

submit limit orders, they are held by a specialist or market maker until the orders

are executed, they expire, or are cancelled. Because they collect these limit orders

submitted by customers, specialists and market makers may obtain informational

and trading advantages. Commission and SRO rules protect customer limit orders

by providing them with priority over specialist and market maker proprietary orders

at the same price on the exchanges and on Nasdaq.6 However, specialists and market makers can ‘‘step ahead’’ of customer limit orders by trading at a price better

than the existing limit order.7

With some variations, the rules of the NYSE and the NASD require that a specialist or market maker who wants to ‘‘step ahead’’ of a customer limit order pay

a price which is greater than the limit order by at least the minimum quoting increment.8 However, with the conversion to decimals, the minimum price increment has

decreased from 1⁄16, or 6.25 cents, to 1 cent. This means that it could be less costly

for specialists, market makers, and possibly certain other market participants to

profit from their knowledge of limit order flow by trading ahead of limit orders for

only a penny a share.9 Public traders may defend themselves from such stepping

ahead practices by using floor brokers to hide their orders, by breaking up their orders, and by switching to market order strategies from limit order strategies. These

responses could increase transaction costs and reduce market transparency.

Since the commencement of decimals trading, numerous articles have appeared in

the press that have raised concerns about increased stepping ahead activity. In addition, the NYSE held a meeting on February 16, 2001 with a cross-section of market participants to discuss several issues related to decimal trading—including

‘‘stepping ahead.’’ The NYSE reported after the meeting that while it believed that

some of the problems associated with decimals may be behaviorally solved, some

other issues might need to be addressed systemically, and has organized committees

to examine these issues and develop possible solutions.

The Commission currently is gathering information about the operation of these

investor protection rules in the decimal environment, and will consider whether action is necessary to protect investors.

Short Sale Regulation

A short sale is the sale of a security that the seller does not own or that the seller

owns but does not deliver.10 In general, short selling is utilized to profit from an

expected downward price movement, or to hedge the risk of a long position in the

same security or in a related security.

Commission Rule 10a–1 is designed to restrict short selling in a declining market.

The rule applies to short sales in any security registered on a national securities

exchange, and uses a ‘‘tick test,’’ which means that a short sale generally must be

28

11 17 CFR 240.10a–1. 12 NASD Rule 3350 prohibits short sales by NASD members in NMS securities at or below

the current best (inside) bid as shown on the Nasdaq screen when that bid is lower than the

previous best (inside) bid (commonly referred to as the ‘‘bid test’’). Rule 3350 contains certain

exemptions, including an exemption for qualified Nasdaq market makers, options market makers, and warrant market makers. The Rule also contains exceptions similar to those provided

under Rule 10a–1. 13See Securities Exchange Release No. 44030 (March 2, 2001) 66 FR 14235 (March 9, 2001). 14The Nasdaq study is due on December 1, 2001. 15Securities Exchange Release No. 42037 (October 20, 1999) 64 FR 57996 (October 28, 1999). 16Securities Exchange Act Release No. 44165 (April 6, 2001), 66 FR 19268. The Commission

also approved on April 6, 2001, a pilot program setting forth protections that must be provided

by specialists and market makers on the Chicago Stock Exchange(‘‘CHX’’) for customer

subpenny orders in Nasdaq securities. Securities Exchange Act Release No. 44164 (April 6,

2001), 66 FR 19263 (April 13, 2001). The Nasdaq and CHX proposals were approved as pilot

programs until July 9, 2001, during which time the markets will supply the Commission staff

with monthly reports on their activity in subpenny increments. 17See text at n. 6, above; NASD IM–3220–2—Trading Ahead of Customer Limit Order.

at a price higher than the last reported sale for the security. 11 The NASD also has

a short sale rule for Nasdaq securities that requires a short sale to be effected at

a price above the current bid in a declining market.12 In a decimals environment,

where price differences between trades can be a penny or less, the question is: how

much above the last sale or the bid must a short sale be?

On March 2, 2001, the Commission took a step toward answering this question

when we approved a change to the NASD short sale rule providing that a ‘‘legal’’ short sale must be executed at a price at least $0.01 above the current best bid.13

In approving this amendment on a one-year pilot basis, we noted that transactions

based on very small price changes could undermine the operation of the short sale

rules. While permitting a $0.01 increment standard for short sales during the initial

stages of the conversion to decimal pricing, we required Nasdaq to submit a study

analyzing the operation of the amended rule.14

Essentially the same question arises in the context of the Commission’s short sale

rule. In addition to our ongoing review of the short sale rule, which was begun in

our concept release in October 1999,15 the Commission’s staff is gathering data and

is considering rule changes to address short selling in a decimals environment.

IV. Subpenny Trading

Many of the regulatory issues that have arisen in a decimal environment may be exacerbated by the practice of trading at increments finer than $0.01, commonly referred to as subpenny trading. For years, some electronic communication networks

(‘‘ECN’s’’) and Nasdaq market makers have permitted trading in increments smaller

than that displayed through the Nasdaq system. This practice has continued in the

decimal environment, with approximately 4 to 6 percent of trades in Nasdaq securities executed in subpenny increments even though the quotations for these securities are at a penny increment. On April 6, 2001, the Commission approved, on a

pilot basis, a rule filed by the NASD specifying the protections Nasdaq market makers must provide to customer limit orders priced in subpennies.16 As noted earlier,

the NASD’s Manning Interpretation requires the execution of a customer limit order

held by a market maker if the market maker trades for its own account at a price

that would satisfy the customer limit order.17 The market maker, however, can

trade for its own account at a price better than the customer limit order and is not

obligated to execute the limit order (so-called ‘‘trading ahead’’). The amendment to

the Interpretation requires market makers who want to trade ahead of customer

limit orders to trade at a price at least $0.01 better than the customer limit order

priced at or better than (inside) the best displayed inside market. For customer limit

orders priced outside the best displayed inside market, a market maker must trade

at a price at least equal to the next superior minimum quotation increment. Because subpennies increase the concerns raised by decimal trading, the Commission

needs to consider the impact of subpenny trading on market transparency and liquidity, as well as investor protection and market integrity rules.

V. Conclusion

The conversion to decimals went smoothly from an operational standpoint, thanks

to the planning and cooperation among regulators, self-regulators, and the industry.

Decimal trading has raised issues that must be carefully considered to ensure our

markets remain transparent, liquid, and fair. As other market challenges have arisen over time, the Commission has embraced these challenges, working to adapt regulatory structures in a manner that will affirm investor confidence and help to lead

our markets into the future. We believe that the conversion to decimals fosters these

29

goals by simplifying pricing and making our markets more competitive internationally. We recognize, however, that there are some aspects of the effects of

decimalization that still need to be considered thoroughly. I want to assure you that

the Commission is working with the markets and the securities industry to address

potential problems while preserving the benefits of decimalization. We appreciate

the Subcommittee’s continuing interest in this issue and the role it has played in

helping to ensure a smooth transition to decimals.

Thank you.

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31

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33

PREPARED STATEMENT OF J. PATRICK CAMPBELL

PRESIDENT, NASDAQ U.S. MARKETS AND

CHIEF OPERATING OFFICER, THE NASDAQ STOCK MARKET

MAY 24, 2001

Introduction

Mr. Chairman and Members of the Subcommittee, I am Pat Campbell, President,

Nasdaq U.S. Markets and Chief Operating Officer, The Nasdaq Stock Market. We

welcome this opportunity to share with you our experience and insights into the recent conversion to decimal pricing on the Nasdaq Stock Market.

As the world largest stock market by every measure other than aggregate market

capitalization (for example, in terms of the number of listings, dollar volume, transaction volume and liquidity), ensuring that decimalization of the market was not

disruptive to investors and the U.S. capital markets was our primary concern. Crucial to our job as the world’s largest provider of stock quote information is maintaining the availability, integrity, and accessibility of this data. The estimates of increased computer system demands made switching to decimals a challenging

project. One study projected a three-fold increase in quotation traffic. Decimalization

takes the market from 16 price points per dollar to 100 price points. Due to the hard

work of our highly skilled employees, member firms and the Securities and Exchange Commission (SEC), I am glad to report that the decimalization was accomplished without incident.

We are proud of the often-cited characterization of Nasdaq as the Engine of the

New Economy. However, we are much more than that. Across the board, we have

been the home to more IPO’s than any other U.S. market, providing crucial access

to capital for new companies of all sizes and types to grow. These companies create

jobs and add vibrancy to local economies. The impact of these benefits are felt in

every State.

Nasdaq is dynamic and is adjusting to changing market realities in order to better

serve our listed companies, member firms, and investors. As you may know, Nasdaq

applied to the SEC to become a registered national securities exchange in November

of last year. We expect the SEC to publish our application for public comment in

the Federal Register in the immediate future, and we are hopeful for speedy approval of our application at the end of the comment period. This process will facilitate final separation of the Nasdaq from the NASD, lead to our ability to access the

capital necessary for our Exchange to invest in new technology in order to remain

a competitor in the world capital markets, and allow us to better serve our constituencies. In order to continue to be the preeminent global competitor, we have recently

taken significant steps such as the March 27, 2001, acquisition of a majority interest

in the pan-European Easdaq stock market, as well as the March 26, 2001, announcement of Nasdaq’s partnership with the London International Financial Futures and Options Exchange to offer single stock futures in the United States. As

you know, Nasdaq Japan, our undertaking with the Osaka Stock Exchange, is operational and is becoming an increasing presence in the Japanese equity market, particularly with respect to IPO’s.

Early Analysis

I would caution that the initial trends are observed through a fast-track analysis

intended to get information to the Subcommittee as quickly as possible. The data

has not yet been verified by independent analysis, but is instructive as an important

benchmark for short-term analysis. It is preliminary and will be continuously revisited as we gain more experience with the new environment. The three most important points I wish to share with you today are:

(1) Nasdaq’s transition from fractions to decimals was smooth and seamless;

(2) Nasdaq’s market has seen a dramatic decrease in spreads; and

(3) There is no evidence on our market, to date, that institutional investors

are bearing the burden of any significant cost-shifting.

Nasdaq’s Seamless Transition to Decimals

To achieve today’s results in a very compressed time frame, virtually every computer system within Nasdaq was changed. This included an upgrade of the Enterprise Wide Network, a change to Nasdaq Workstations to allow for the display of

decimal information, replacement of front-end processors with a higher-capacity

computer architecture that allows for quoting and matching of decimals trades, and

upgrades to back-office batch processing systems that calculate indices, dividends,

etc. A similar effort took place among Nasdaq broker-dealers that required them to

assess and redesign their systems and business models. This followed the first two

34

pilots of decimalization for 212 Nasdaq stocks and 3 OTC Bulletin Board (OTCBB)

securities in March 2001. On April 9, 2001, all remaining Nasdaq-listed securities

began being quoted in a decimal format with a $0.01 minimum price increment (for

example ‘‘tick size’’). Thus, Nasdaq has successfully completed the full conversion to

decimal quoting and trading in approximately 1 month. Nasdaq has been carefully

monitoring the impact of decimalization both through our on-line surveillance and

market operations group and by gathering and analyzing data for the 2 week period

prior to decimalization and comparing it to the 2 week period following

decimalization (March 26, 2001–April 20, 2001). I would like to add that Nasdaq

set a new share volume record only 7 days after full conversion to decimals—3.19

billion shares—and was able to handle that volume without incident.

Among the major concerns raised by conversion to decimals is the capacity impact

on message traffic. There are two general classes of messages: quote updates disseminated by the various market centers and the Last Sale trade report disseminated by Nasdaq. We found that the number of quote updates for stocks increased

by at least 12 percent after controlling for the day-to-day fluctuation in trading activity for the overall market. The Nasdaq systems have ample capacity to handle

this increase.

As expected, decimals did not significantly increase the overall market trading

activity. On average, stocks experienced only a 5 percent increase in trades and a

less than 1 percent increase in volume.

Dramatic Decrease in Spreads

As expected, quoted bid-ask spreads declined substantially for most stocks. A

quoted spread is an appropriate measure of costs for retail investors placing small

market orders. All types of stocks saw dramatic decreases in quoted spreads; on average, the quoted spreads decreased by 51 percent. All else being equal, the decline

was greater for more active and lower price securities—our most active stocks saw

a 71 percent spread decline. Many of Nasdaq’s most well known and widely held

stocks, such as Cisco, Dell, Intel and Microsoft and others, now have quoted spreads

of one cent. Similarly, effective spreads (spreads that take into account actual trade

prices) declined for all stock groups by an average of 46 percent. This is in addition

to the 30 percent decline seen following the order handling rules and move to sixteenths in 1997.

Many people expected the intra-day volatility to increase as a result of

decimalization, the frequent change of the inside quotes. We use three measures of

intraday volatility to analyze this issue:

• average magnitude of trade-to-trade price changes; • average volatility of duration-weighted bid-ask-midpoint; and • percentage differences of high and low prices of the day.

In all three measures, we did not detect any noticeable increase in volatility. In

fact, the data indicates a decrease in volatility, consistent with what we found for

the pilot issues. It should be noted that volatility, as measured during this time

frame, could be influenced by a number of other market factors independent of

decimalization.

Investor Costs

We also reviewed the extent to which penny increments have caused orders to be

broken into smaller trades. We looked for trends in trade size by looking at the average number of shares per trade report. Contrary to what some academics had predicted, according to early indications the average trade size for the decimalized

stocks decreased only by 4.6 percent. Obviously, this is a calculation that would be

benefited by covering a longer time period.

The price dimension of quotes tells only part of the story. The quoted size is also

significant. The Nasdaq quote montage is not a consolidated limit order book. Market makers frequently fill orders for far more size than indicated by their quotes,

and they often fill orders at prices better than their own quotes. Nevertheless, analysis of the impact of decimals on displayed depth is of interest as it may be indicative of the total level of liquidity provided by the market. A more definitive analysis of liquidity postdecimals awaits future research.

Quoted depth at the inside quotes declined for the newly-decimalized stocks.

Again, recall that decimalization moved from 16 price points per dollar to 100 price

points. We looked at two measures of inside depth, the average aggregate quoted

depth at the inside and the number of market makers and electronic communications networks (ECN’s) displaying quotes.

This week, another effort was made by Nasdaq to analyze decimalization to understand its impact, if any, on institutional trading cost. While we believe this analysis is preliminary, we found good news for institutional trades on Nasdaq. It does

35

not appear that decimalization on Nasdaq has caused higher institutional trading

costs. A reasonable proxy to evaluate the cost of trades is to look at effective

spreads. We know decimalization had a huge impact on retail trades, as effective

spreads dropped by about 50 percent. We found that trading costs (effective spreads)

fell for institutional trades as well. Effective spreads are based on actual trade

prices, which are sometimes better and sometimes worse than the posted bid-ask

quotes. The effective spread is defined as the twice the difference between the trade

price and the average of the bid and ask (i.e, the quote midpoint).

We looked at large trades, and institutional trades specifically, to see if

decimalization thinned-out the market and caused those effective spreads for large/

institutional trades to increase. We believe they did not. Our attempt to use our

data showed ‘‘institutional’’ prints got better fills (lower effective spreads) after

decimalization (although by insignificant amounts for 5,000-shareprints and higher)

but the fills were slower. Again, this is based on the early days of decimal trading— as trading/sales practices adapt, this could change.

One issue that has caused significant controversy with the shift to decimals is ‘‘pennying’’ or trading in front of a standing order by a penny. On this issue it is

useful to recognize the advantages allowed by the Nasdaq market model of an all

electronic market with competing dealers and ECN’s. Nasdaq’s quotes may be electronically accessed with no participant being provided a second look, we have not

heard significant institutional concerns expressed about ‘‘pennying’’ on Nasdaq. We

believe competing market makers and ECN’s provide a hybrid market environment

that discourages such unfortunate behavior. In fact, it is important to note that

Nasdaq has been trading in increments finer than pennies since before April 9,

2001. Decimalization for Nasdaq pertained to quotes. We do recognize, however,

that some institutional investors retain significant concerns over the impact of

decimalization on market liquidity and we will continue to aggressively monitor our

market to identify any basis for such concerns.

Conclusion

Overall, the implementation of decimal trading for all Nasdaq stocks was carried

out smoothly, as anticipated, with respect to capacity and market quality.

Decimalization is a success story for Nasdaq, the industry and the American economy. We could not have accomplished it without the full cooperation of our member

firms and their technology providers and the SEC.

Most of the results are consistent with what we had anticipated. Indeed, overall

spreads declined by a larger-than-expected percentage. Investors are seemingly enjoying some improvement of prices because of the tightened spreads.

That said, we want to caution that decimal trading is still in a preliminary stage.

As more time passes, we could see the results change over time. We plan to conduct

our final detailed analysis for all three phases of decimalization for the SEC soon.

Thank you for the opportunity to share Nasdaq’s experiences with decimalization.

I would be happy to respond to your questions.

—————

PREPARED STATEMENT OF CATHERINE R. KINNEY

GROUP EXECUTIVE VICE PRESIDENT, NEW YORK STOCK EXCHANGE

MAY 24, 2001

Chairman Enzi, Senator Dodd, and Members of the Subcommittee: My name is

Catherine Kinney, and I am Group Executive Vice President of the New York Stock

Exchange (‘‘NYSE’’ or ‘‘Exchange’’). I am pleased to be here today to relate some of

the preliminary results of decimal trading.

Decimalization has been the most important occurrence in our capital markets in

the last quarter-century. Congress and the SEC directed this initiative to accomplish significant policy goals. The NYSE is pleased to have facilitated the conversion

process. The benefits of decimal trading have been realized, but the shift to a minimum price variation (‘‘MPV’’) of 1 cent has created some difficulties. The NYSE is

already taking steps to remedy some of these detrimental effects. In this regard, we

urge that an MPV of no less than 1 cent be established by Congress or the SEC

across all markets. Otherwise, the current difficulties will become worse, and the

benefits of decimalization may be jeopardized.

Conversion to Decimals

The Exchange recognizes that conversion to decimals was a high priority for a

number of Congressional leaders and for the Securities and Exchange Commission

(‘‘SEC’’ or ‘‘Commission’’). The Exchange made a commitment to convert to decimals,

36

and we are proud that our conversion was accomplished without systems or capacity

problems. Most of our decimal conversion costs were incurred simultaneously with

our Year 2000 system conversion. These simultaneous system upgrades cost approximately $30 million.

Decimal trading has increased the number of possible trading increments within

a dollar from 16 to 100. This increased number of trading increments has required

an increase in capacity for our trading systems. Since 1988, we have spent nearly

$3 billion on technology to maximize capacity. We currently have the capacity to

trade five times our average daily volume. Today, the NYSE has sufficient capacity

to handle 2,000 messages, or orders, per second. Stated differently, capacity is 6

billion shares per day.

The Exchange launched decimal trading with a pilot project of seven stocks on

August 28, 2000. Stocks in the pilot program were priced in dollars and cents instead of fractions, and the minimum pricing increment was one penny instead of

1⁄16 of a dollar. The pilot was extended to include 57 additional stocks on September

25, and 94 stocks were added on December 4. The Exchange completed the conversion by trading all 3,525 listed issues in decimals on January 29, 2001, more than

2 months ahead of the SEC’s deadline of April 9. Throughout the conversion process,

all Exchange systems performed efficiently and without problems.

Trading in a Decimal Environment: The Early Results

We are confident that the conversion to decimal pricing has accomplished important public policy goals: It has brought U.S. markets into conformity with quoting

and trading systems used around the world. This will help U.S. equity markets to

expand their foreign listings, and will facilitate globalization of equity markets.

Our preliminary analysis of conversion to decimal pricing indicates that, on balance, the penny increment has been good for some retail investors. Stock prices in

decimals are certainly more understandable. Over the last decade, direct share ownership by individual investors has increased, and decimal prices will encourage this

trend by breaking down a barrier to understanding the market. Spreads have been

reduced, and price improvement on the NYSE has increased.

The smaller price variation (a penny) encourages price competition. Results to

date indicate a tightening of the bid-ask spread—the differential between the highest quote to buy (the ‘‘bid’’) and the lowest seller’s asking price (the ‘‘ask’’)—by approximately 37 percent. This is particularly beneficial to small investors, especially

those trading in the most active stocks.

We have also seen an increase in price improvement, particularly for smaller orders. In orders that do not exceed the quoted size of the best bid or offer, the price

improvement rate on the NYSE has increased from 35.2 percent to 50.7 percent.

On the other hand, the one-cent MPV has significantly impacted institutional investors. The Exchange has monitored, and continues to monitor, the effect of this

change on investors and on the operation of the market. The market is continuing

to acclimate to this new environment, and it is premature to draw any sweeping

conclusions. But, we have observed some trends that I will summarize.

Decimal trading has had a number of detrimental impacts on mutual funds, pension funds and other institutional investors, who act on behalf of individual investors. These investors, who tend to trade in large blocks, have experienced a lack of

transparency and reduced depth at the published NYSE quote (best bid and offer),

and an increase in number of execution reports (for example, the number of transactions necessary to fill an order). These market participants are an important

source of liquidity.

We conducted a one-week analysis of a random sample of 150 stocks to assess the

degree to which trades occurred at a minimum variation before and after

decimalization when the bid or offer equaled or exceeded 10,000 shares. We found

a significant decrease in occurrence in a one-cent variable compared to a 1⁄16 variable. We also found that a majority of these occurrences were initiated by a floor

broker or an order received through the Super Dot system, rather than by a

specialist.

The impact on the institutional investor is an inevitable outgrowth of the decrease

in the minimum price variation from 6.25 cents to one cent. This decrease in the

MPV has lowered the transparency of the market and thus made it harder for institutional investors to find the right price for the liquidity they require.

Our research to date shows a significant 67 percent decrease in the number of

shares available at the published NYSE quote. While true liquidity (for example,

actual interest from all sources) available may not have been significantly impaired,

there has been a significant impairment of transparency.

Nevertheless, because liquidity is spread-out over a number of price points, institutions have found that it takes significantly more trades in a decimal environment

37

to execute a large order compared to trading in sixteenths. We have canvassed institutional investors serving on our Institutional Traders Advisory Committee, Pension

Managers Advisory Committee and Advisory Committee on Decimalization, and this

has been a leading complaint.

We have acted to address the transparency concerns of the institutional investor.

The Exchange has initiated two changes to pemit dissemination of ‘‘depth indications’’ and ‘‘depth conditions’’ in our listed securities. These initiatives are the first

in a series of actions the Exchange will implement to improve transparency and

communication of market depth in a decimal trading environment.

In March, the Exchange began to disseminate an ‘‘indicator’’ of additional market

depth. The range is currently defined as 20,000 shares within 15 cents of the bid,

offer, or both. Part two of this effort began this week, with the ability to disseminate

‘‘depth conditions.’’ The ‘‘depth condition’’ shows liquidity beyond the best bid or

offer without the predefined, limited parameters of the ‘‘depth indicator’’.

In addition, next month, we intend to introduce Open Book, which will provide

data in orders residing at each price point in specialists’ display books. We also are

proliferating hand-held technology called E-Broker, which allows floor brokers to

electronically communicate ‘‘market looks’’ at the market depth to customers from

the point of sale.

In addition, we have formed an Advisory Committee on Decimalization to review

decimal trading at the Exchange and to make recommendations based on that assessment. The Committee is comprised of representatives from various Exchange

constituencies, including representatives of our Pension Managers Advisory Committee, Institutional Traders Advisory Committee, the NYSE Board of Directors,

and specialists and floor brokers. As more definitive information becomes available

from our review of the effects of decimal pricing, we will share it with the SEC.

The Future

The work of the Advisory Committee on Decimalization is ongoing, and it will continue meeting to consider initiatives to facilitate price discovery in a decimal environment. We are reviewing Exchange trading rules to ensure that they are appropriate for the changes that are occurring. We will also be working with academics

to study these issues.

The SEC has requested that we provide a preliminary report by September 10 on

the impact of decimal pricing on systems capacity, liquidity, and trading behavior,

including an analysis of whether there should be a uniform minimum increment.

The SEC has further requested all markets to submit by November 4 proposed rule

changes establishing their individual choice of minimum pricing increments.

We believe an MPV of less than a penny would undermine the benefits that decimal pricing has brought to the markets, while at the same time exacerbating the

problems that decimal pricing has caused for institutional investors. An MPV of less

than a penny would provide no real benefit for individual investors. It would reverse

the harmonization of U.S. pricing with that of overseas markets. And it would be

a step backward in improving clarity of stock prices for individual investors.

In addition, the problems that institutional investors have faced in trading at an

MPV of one cent would increase exponentially if markets were permitted to quote

and trade in increments of less than one cent.

If the SEC decides to establish an MPV greater than a penny, we believe that

the variation should apply to trades and quotes; to trade at a variation lower than

the quote minimum would give dealers an unfair advantage.

The NYSE intends to be competitive in the marketplace under all circumstances

as it relates to the issue of the MPV, and will continue to assess the best means

of addressing the transparency problem resulting from liquidity dispersed over more

price points.

I appreciate the opportunity to testify today, and I would be pleased to answer

any questions.

—————

PREPARED STATEMENT OF KENNETH D. PASTERNAK

CHAIRMAN AND CHIEF EXECUTIVE OFFICER, KNIGHT TRADING GROUP, INC.

MAY 24, 2001

Chairman Enzi, Senator Dodd and Members of the Senate Banking Securities and

Investment Subcommittee, thank you for this opportunity to testify today about the

impact of trading in decimals. My name is Kenny Pasternak. I am Chairman, Chief

Executive Officer, President, and Co-Founder of Knight Trading Group, the world’s

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1 Nasdaq Economic Research defines the effective spread as twice the absolute difference between the actual trade price and the prevailing bid-asked mid-point.

largest wholesale market maker for shares of both Nasdaq and non-Nasdaq equities.

We are also a growing options market maker and an asset manager.

At Knight, we like to think of ourselves as providing the processing power behind

the explosive growth in securities trading via the Internet. We founded Knight with

the purpose of empowering self-directed individual investors—to give them the same

speed, low cost and dependability in their securities transactions long enjoyed by

large institutional investors. We are committed to offering the same efficient, dependable service, whether people wish to trade a single share of stock or a thousand

shares—so our interest in the issues under discussion here today is acute.

The Subcommittee has asked me to assess how decimal pricing is affecting the

trading environment; whether the anticipated benefits of decimalization are being

realized; and whether the transition to decimalized trading has brought about a

need for change in securities regulations.

Decimal Pricing Has Led To Reduced Spreads But Not

Always Lower Trading Costs

To answer the first of these questions, U.S. stock markets recently adopted

decimalized trading in the belief that it would narrow spreads and lead to less costly

order execution.

There is no doubt that spreads have fallen. According to preliminary data, quoted

spreads for Nasdaq stocks have fallen by an average 51 percent since the advent

of decimalized trading. The decline has been greatest for the most active, lowerpriced securities, which saw a 71 percent decline in quoted spread. Effective

spreads 1—a better measure of investor cost—fell by an average of 46 percent.

It is important to note that the introduction of decimalized pricing is not in itself

responsible for the narrowing of spreads. Rather, spreads have narrowed as a result

of the decision by major market centers to reduce their Minimum Price Variation,

or MPV. In 1997, when the major market centers dropped the MPV from one-eighth

of a dollar (12.5 cents) to one-sixteenth of a dollar (6.25 cents), the narrowing of

spreads reduced trading costs for many investors, but increased costs for others.

With the MPV now at a penny, the number of investors for whom costs have increased has been magnified. In other words, a higher percentage of orders are being

processed less efficiently.

Today’s one-penny MPV has reduced price discovery, diminished liquidity and increased the level of trading activity required to execute an entire order. No market

participant has an incentive to quote in size, as others can easily coopt that information and trade ahead by as little as one penny. While such problems were once experienced only by institutional investors, they now affect increasing numbers of

individual investors as well.

Knight Trading Group supports decimalization. We believe that by making stock

prices easier to understand, decimalization encourages market participation and,

therefore, benefits everyone. My purpose today is to focus this Subcommittee’s attention on the adverse effects of the dramatic reduction in MPV adopted by the major

market centers at the time when they implemented decimal pricing.

The one-penny MPV is, in many circumstances, too small. In my view, the most

important issue for this Subcommittee’s consideration is how to encourage the markets to arrive at the correct MPV for a given set of circumstances. The thrust of

my testimony today will be to explain why this issue is vital to the depth, liquidity

and overall strength of our markets.

How the One-Penny MPV Hurts Investors

The major market centers’ recent adoption of the one-penny MPV has had enormous unintended consequences. Preliminary data suggests that, even for retail-sized

orders, trading outside the spread has increased dramatically. The price discovery

process has been impeded because displayed depth on Nasdaq has also declined—

to approximately one-third of what it was before the transition to trading in decimals. Meanwhile, we see that more and more investors feel compelled to break

down their buy and sell orders into smaller lots in order to achieve more control

over their executions. Trades generally have increased in number but declined substantially in size.

In addition, the one-penny MPV has occasioned a significant decline in the average number of market participants at the inside quote. In other words, those who

provide enhanced liquidity to the markets are now committing less capital for the

execution of individual investor trades than they did before the one-penny MPV.

39

Those who proactively provide enhanced liquidity constitute a large and highly

competitive industry that is absolutely essential to the efficient operation of the

markets. They often provide liquidity automatically in amounts larger than the National Best Bid and Offer (NBBO). This automatic execution feature expands as the

MPV increases and shrinks as the MPV decreases.

At present, because of the one-penny MPV, many retail investors are paying more

as the nature of executions changes from fast and complete to slow and fragmented.

For example, during the month of January, Knight Securities alone provided liquidity above the NBBO size level in excess of 179 million shares. Without our enhanced

liquidity, we estimate conservatively that investors would have paid nearly $4 million more in execution costs.

With the advent of the one-penny MPV, however, we and our competitors are providing enhanced liquidity in many fewer instances. Whereas, we previously provided

instantaneous automatic execution at the NBBO price for any order of up to 2,000

shares, we now reserve automatic execution for much smaller orders. And in many

instances, we do not offer automatic execution no matter how small the order.

This decline in the availability of enhanced liquidity for Nasdaq stocks, coupled

with the lower average quoted size, translates into slower and more fragmented executions—and ultimately higher costs for investors.

In the listed markets, what we are seeing is a pronounced increase in the number

of ITS ‘‘trade-throughs.’’ As you know, ITS—the Intermarket Trading System—is

the linkage between the major exchanges and other trading centers. When an ITS

participant like a New York Stock Exchange specialist sees another trading center

offering a better price for more than a hundred shares, the specialist is obliged to

either match that price or else forward the order on the investor’s behalf. When the

specialist fails to make good on that obligation, the omission is known as a ‘‘tradethrough.’’ It means that the investor may actually receive a price dis-improvement.

Our subsidiary, Knight Capital Markets (or KCM), which trades New York and

American Stock Exchange listed equities on the Nasdaq InterMarketTM, has seen

a marked increase in the number and frequency of Exchange member tradethroughs. During the first six trading days in February 2001, when decimal trading

was introduced in all listed stocks, KCM experienced an average of more than 2,500

trade-throughs per day by NYSE members—a more than four-fold increase over the

predecimalized period.

Anachronistic Rules and Regulations Need To Be Reviewed

Before investors can realize the full benefits of decimalization, including cheaper

order execution, Congress, the SEC and the major market centers must address the

negative consequences of narrowing spreads. Some of the blame can be traced to

outdated rules and regulations that were written for an era of fractional pricing and

substantially larger MPV’s.

One area that needs review is the long-held notion that our NBBO’s standard provides the most accurate barometer as to whether an investor has received best execution. The concept of best execution remains a cornerstone of our markets, implying that broker-dealers have a duty to seek the most advantageous terms for their

customers’ transactions.

For many years, the NBBO has been regarded as the ultimate measure of best

execution. The NBBO, the consolidated stream of transaction reports and quotations

mandated by Congress in 1975, has been available to the public on a real-time

basis. Retail investors have come to expect automatic execution for orders up to a

thousand shares at the NBBO’s price or better.

Automatic executions and guaranteed liquidity are decreasing as liquidity providers become less proactive. It is time to acknowledge that the NBBO has become

less indicative of market liquidity. With the advent of the one-penny MPV, the

NBBO has lost its value for all but the smallest orders. It gives no indication as

to the price at which many orders can be executed in their entirety and at what

speed.

Indeed, the NBBO’s prices can actually mislead the public with respect to the

quality of order executions available among various market centers trading the

same issues. The quality of executions afforded investor market orders by various

market centers can vary widely in relation to the consolidated NBBO at the time

of order receipt. The price at which an order was executed may not reflect the greater liquidity that might have been available at a competing market center. In short,

the NBBO should no longer be regarded as sacrosanct.

Best Execution Entails More Than Getting the Best Price

In many instances, price should not be the primary consideration in determining

best execution. In the past, a broker-dealer could argue persuasively that it had disVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6621 78288.TXT SBANK4 PsN: SBANK4
40

2 Arthur Levitt, Dynamic Markets, Timeless Principles, Remarks at Columbia Law School,

New York, NY (September 23, 1999) (transcript available at http://www.sec.gov/news/speeches/

spch295.htm) (emphasis added).

charged its best execution obligation merely by providing price improvement. Today,

however, in an environment of narrowed spreads and diminished liquidity, providing price improvement may be less important than executing an order promptly

and in its entirety. Broker-dealers should be obligated to consider such criteria as

order size in seeking the destination that will provide the best execution.

Other Impediments to Fairer, More Efficient Markets

While the Subcommittee and the SEC are reviewing the rules governing the

National Market System, we would encourage them to consider a number of other

impediments to fairer, more efficient markets. These include:

• The issue of connectivity, as manifested through market-center linkages.

• The proper means of encouraging market participants to quote and perform price

discovery in larger sizes.

• The Short Sale Rule and other outmoded regulations that actually impede the efficient handling of orders. Short-selling by market professionals increases market

liquidity, helping to offset temporary imbalances in supply and demand. It also

reduces the risk that the price paid by investors will be inflated by temporary

supply impediments.

• And finally, the need for a new Trade-Through Disclosure Rule for equities, similar to the rule recently adopted by the SEC for options trading. Such a rule would

require broker-dealer disclosure whenever a customer’s order is executed at a

price that is inferior to a published quote on another exchange. The rule would

not supplant the broker-dealer’s duty to provide best execution, but it would provide investors with the means to monitor broker-dealer performance, while encouraging broker-dealers to develop effective means of accessing better quotes

published by other markets.

Conclusion

Let me conclude by citing the words of recently retired SEC Chairman Levitt:

It is not the pace of technology or the brilliance of innovation . . . that

guarantees the success of our markets, but rather an unyielding commitment to quality. Quality in the marketplace is faster, cheaper execution of

transactions . . . [and] efficient price discovery. Quality is the best execution of customer orders. Quality . . . is the protection of the investor interest. This last principal . . . reaffirms a simple and salient truth—markets

exist by the grace of investors.2

That same ‘‘simple and salient truth’’ is at the heart of the issues we are discussing today: Whether our domain is Wall Street or Main Street, we are obliged

to do what best serves the interests of all investors—large and small.

The implementation of trading in decimals has made the markets more accessible

to investors, but it has also led to a number of profound changes that diminish market liquidity, as well as the speed and efficiency with which investor orders are

being executed.

Only by recognizing and adapting to the changes occurring in the U.S. markets

can we continue to protect the investor, strengthen market integrity, and maintain

the position of leadership that our markets enjoy globally. Therefore, we hope that

Congress and the Commission will review the Securities Exchange Act of 1934—especially its rules regarding the National Market System—then take the necessary

steps to create markets that are fairer and more efficient for the largest possible

number of trading participants.

As this Subcommittee ponders the significant public-policy issues surrounding

decimal pricing, my colleagues and I at Knight would welcome any opportunity to

contribute further to the discussion.

Thank you.

41

1The Securities Industry Association brings together the shared interests of nearly 700 securities firms to accomplish common goals. SIA member-firms (including investment banks, brokerdealers, and mutual fund companies) are active in all U.S. and foreign markets and in all

phases of corporate and public finance. The U.S. securities industry manages the accounts of

approximately 50 million investors directly and tens of millions of investors indirectly through

corporate, thrift, and pension plans. In the year 2000, the industry generated $314 billion of

revenue directly in the U.S. economy and an additional $110 billion overseas. Securities firms

employ approximately 770,000 individuals in the U.S. (More information about SIA is available

on its home page: http://www.sia.com.)

PREPARED STATEMENT OF DONALD D. KITTELL

EXECUTIVE VICE PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

MAY 24, 2001

I am Donald D. Kittell, Executive Vice President of the Securities Industry Association.1 SIA worked with its member firms, the U.S. equities and options exchanges

and Nasdaq, clearance and settlement organizations, service bureaus, market data

vendors and the Securities and Exchange Commission to successfully convert the

U.S. equities and options markets from fraction-formatted trading to decimalformatted trading earlier this year. The conversion took 3 years to accomplish and

cost in excess of $1 billion, according to estimates developed by the Tower Group

on behalf of SIA. The conversion itself was accomplished smoothly, to the credit of

all participants involved.

I have organized my comments on the impact of decimalization into four subjects:

I. Systems and Operations

II. Trading Rules and Regulations

III. Market Making

IV. Investor Benefits

I would summarize SIA’s conclusions on the impact of decimalization as follows:

(1) The systems and operational aspects of the conversion went extremely well,

primarily as a result of a carefully constructed phase-in process of pilot trading,

testing and evaluation by each market participant. Industry participants worked

well together to accomplish the conversion—literally without incident. Thus far, actual message traffic has not reached the levels that early studies anticipated; however, it is still early to conclude that message traffic projections were overstated.

(2) Trading rules and regulations are currently under study by market participants, self-regulatory organizations and the SEC. These rules address minimum

price variation, short sales, limit order disclosure and protection, trade throughs,

best execution, locked and crossed markets and block trading. It seems clear that

timely adjustments to some of these rules are required.

(3) The economics of trading and market making are under intense review by

market participants and may be expected to result in changes in strategies and

practices by securities firms and institutional trading desks. We expect this process

to evolve over many months.

(4) It is clear that the benefit of decimalization to investors is a complex subject

which will be debated for some time. It is clear that the simpler ‘‘language’’ of decimals is a benefit. It is also clear that the harmonization of decimals across products

and across international markets is a benefit. SIA believes that removal of the cloud

of suspicion surrounding fractions was a constructive step. Conclusions about market liquidity, trading volume, volatility transaction costs, global competitiveness and

the relative economic impacts upon market participants would, in our judgment, be

premature.

Each market center is required by the SEC to submit a study to the Commission

regarding the impact of decimal pricing on systems capacity, liquidity, and trading

behavior, including an analysis of whether there should be a uniform minimum increment for a security. These studies are due June 9, 2001. In the interim, Nasdaq

has released three decimal impact studies which area very useful. SIA has not seen

impact studies from the other exchanges.

I. Impact of Decimalization on Industry Systems and Operations

(1) The securities industry’s conversion of the equity and options markets to decimals took place, for listed securities, on January 29, 2001 and for Nasdaq securities

on April 9, 2001. The conversion proceeded smoothly and essentially without incident. All industry participants—exchanges, Nasdaq, specialists, market makers,

data vendors, service bureaus, clearance and settlement organizations and securities

firms reported a seamless transition.

(2) The conversion to decimals followed 34 months of planning, coordination and testing. The cost of the conversion is estimated at in excess of $1 billion, by the

42

Tower Group on behalf of SIA. These costs include programming changes, capacity

increases and internal, as well as industry testing.

(3) Message traffic (quotes, trades and administrative messages) has not risen to

the levels projected by SRI Consulting in April 1999; however, it should be noted

that SRI’s projections were made during a period of very high market activity and were ‘‘as of’’ December 31, 2001. We do not yet have experience in a market environment comparable to early 1999.

(4) The SRI message traffic projections for options trading presented the most serious challenge to capacity. The options markets have introduced multiple listing,

the quoting of size and the launching of a new Exchange at the same time as the

conversion to decimals. As a result, the options exchanges have decided to trade in

minimum price variations of 5 cents and 10 cents, instead of in pennies.

(5) Market makers, specialists and trading desks report an increase in administrative workload as a result of the increase in trading increments. This workload

deals with increases in cancels, cancel-and-replaces, rejects and breaks, as well as

the increased number of partial executions and executions per order. SIA has not

attempted to quantify the increase in workload. It would be reasonable to assume

that as market participants adapt to the decimal environment, productivity should

improve.

(6) Some SIA firms have raised concerns about the lack of a standardized decimal

format in the Nasdaq market. The NYSE listed market provides that quotes and

trades take place in pennies, with average prices of block trades carried out to four

decimal places. The Nasdaq market provides that quotes be in pennies, but has no

similar standard for trades. As a result, some Nasdaq market makers and ECN’s

execute trades carried out to mills, with the number of decimal places to the right

of the decimal varying by participant. This lack of standardization is confusing and

may result in operational inefficiency.

II. Impact of Decimalization on Trading Rules and Regulations

The conversion to decimals impacts at least four sets of trading rules and regulations. The exchanges, Nasdaq, self-regulatory organizations and SIA’s regulatory

and trading committees are currently reviewing these rules and regulations as the

industry gains experience in decimal trading.

(1) Minimum Price Variation: The NYSE currently quotes and trades in penny

increments. Nasdaq quotes in pennies but allows trading in mills. The options exchanges currently quote and trade in increments of 5 cents for options priced under

$3 and of 10 cents for options priced over $3.

Each Exchange is anticipated to make recommendations as to minimum price

variations in its June study.

(2) Rules that are ‘‘triggered’’ by price ticks: A number of SEC and SRO rules are

‘‘triggered’’ by price ticks. Examples include the short sale rules, limit order disclosure and protection rules, and the intermarket trading system trade-through rule.

Decimalization has resulted in industry participants questioning whether these

rules can be effectively managed in a fast moving environment of fluctuating penny

(or mill) ticks. Participants also question whether such ticks are economically significant. It may be that some of these rules should be triggered by large tick sizes.

(3) Best Execution Rules: The concept of ‘‘best execution’’ has been debated in the

industry for many years, but the smaller pricing increments of decimals complicate

the debate. It has long been recognized that the characteristics, which define ‘‘best

execution,’’ include factors other than pure price, such as speed of execution and size

of trade. Decimalization has resulted in finer pricing increments, and at least in the

case of Nasdaq, a greater number of trades outside of the best bid and offer.

The SEC has recently adopted two new rules governing the Disclosure of Order

Execution and Routing Practices (Rule 11 Ac 1–5 for market centers and Rule 11

Ac 1–6 for broker-dealers).

Some SIA firms are concerned about the accuracy of the data that they will be

reporting and the conclusions that may be drawn from this data particularly about

trades executed outside of the best bid and offer for legitimate business reasons.

Reporting under the SEC’s new disclosure rules will begin in June and be phased

in between June and October 2001. SIA anticipates a great deal of discussion among

industry participants, regulators and third-party observers as to the accuracy and

meaning of the newly reported data in a decimal environment.

(4) Block Trading Rules: Institutional trading desks have voiced concerns about

the reduction in displayed depth as a result of decimalization, as well as problems

with entering limit orders and the breaking up of large orders as they interact with

the NYSE auction.

SIA understands that a committee formed by the NYSE is addressing these and

related issues. We look forward to the recommendations of this committee, as well

43

as to the introduction by the NYSE of new functionality to provide greater information about market depth. We understand that Nasdaq is also addressing the issue

of greater displayed depth.

The ways in which market centers deal with integrating the institutional and retail markets to insure fairness to all market participants is a critical issue, made

more complex by the conversion to decimal trading.

III. Impact of Decimalization on Market Making

Decimalization has resulted in significant reductions in the quoted spreads (and

‘‘effective spreads’’) reported by market centers. The reduced spreads have given rise

to conjecture as to the impact of decimalization on specialist and market maker

profitability, the future viability of payment for order flow, the prospect of Nasdaq

market makers introducing commissions on top of ‘‘net trades,’’ a possible increase

in proprietary trading by market makers, the potential for capital being withdrawn

from unprofitable market making activities and other issues of concern to market

makers. SIA firms are addressing these issues individually, and when appropriate,

in trading and regulatory committees.

SIA’s conclusion at this stage of decimal trading, is that it is too early to tell how

these issues will resolve themselves. The conversion from one-eighth trading to onesixteenth trading took a number of months to settle down and the introduction of

the new order-handling rules continues to evolve. It may be many months before

we see a clear picture of the impact of decimalization on market making activities.

IV. Impact of Decimalization on Investors

It is clear that the benefits of Decimalization to investors is a complex subject

which will be debated for some time. It is clear that the simpler ‘‘language’’ of decimals is a benefit. It is clear that the harmonization of decimals across financial

products and across international markets is a benefit. SIA believes that removal

of the cloud of suspicion surrounding fractions was a constructive step.

SIA has always been skeptical about the assertion that Decimalization would

produce huge savings for investors as a result of reduced spreads. The arithmetic

supporting this assertion is too simplistic to consider the effects of price movement,

trade size, liquidity, transaction costs and other factors that govern the economics

of trading.

SIA has also been skeptical about the issue of global competitiveness. A study conducted by SRI on behalf of SIA indicates that the U.S. equity markets are more

than competitive with international equity markets in spite of the use of fractions.

SIA firms report complaints from both institutional and retail customers relative

to the number of trades and the time required filling an order. Institutional firms

report complaints about their inability to see displayed depth and to find liquidity.

Conclusions about market liquidity, trading volume, volatility, transaction costs,

and the relative economic impacts upon market participants—institutional and retail customers, as well as market markers and specialists—would, in our judgment,

be premature until trading behavior settles down over the course of many months.

We also suspect that it will be difficult to generalize these conclusions because experience will vary by type of security, type of market center, and type of customer.

Further, the experiences of each of these groups will vary as market activity

changes over time.

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1Zurich Scudder Investments is the global investment management business of Zurich Financial Services Group (ZFSG). ZFSG is a global leader in the financial services industry, providing

its customers with solutions in the area of financial protection and asset accumulation. The

Group concentrates its activities in five business segments: nonlife and life insurance, reinsurance, Farmers Management Services and asset management. Headquartered in Zurich, Switzerland, the Group’s worldwide presence builds on strong positions in its three key markets: the

United States, the United Kingdom and Switzerland. It has offices in more than 60 countries

reaching 35 million customers and employing 73,000 people (30,000 of which are in the United

States). Based on consolidated figures for 2000, the Group achieved gross premiums of USD 50

billion. This amount includes insurance deposits, as well as premiums from the Farmers P&C

Group. The net income amounted to USD $2.33 billion.

PREPARED STATEMENT OF PETER JENKINS

MANAGING DIRECTOR AND HEAD OF GLOBAL EQUITY TRADING

ZURICH SCUDDER INVESTMENTS

MAY 24, 2001

Good morning, Chairman Enzi, Senator Dodd and Members of the Subcommittee

on Securities and Investment, I thank you for the opportunity to comment on the

implementation and future of the decimalized market. My name is Peter Jenkins

and I serve as Managing Director and Head of Global Equity Trading at Zurich

Scudder Investments.1 Zurich Scudder Investments manages nearly $400 billion in

individual accounts, institutional portfolios and mutual funds, as well as private equity, private debt and hedge fund assets. Our clients include individuals, institutions, corporations, retirement funds, pension plans and insurance companies. It is

important to note that while Zurich Scudder Investments, as well as other mutual

funds, are correctly viewed as institutional investors because we frequently execute

large sized-orders, we are acting on behalf of the millions of individual investors

who put their trust in us to invest their money.

As a trader for the last 21 years, I speak today on behalf of Zurich Scudder Investments, though the views that I express are shared by the Investment Company

Institute, as well as many of my colleagues on the buyside. My comments today will

illustrate some of the practical frustrations we as institutional traders face daily.

I submit that the suggestions I offer will enhance overall market efficiency, which,

in turn, will benefits all market participants and U.S. consumers.

As a preliminary comment, I would like to point out that I strongly support the

move to decimal pricing in the U.S. securities markets and the trading of securities

in minimum increments of one penny. The move to smaller trading increments reduces the spread in securities, which in turn will result in benefits to our shareholders. In addition, the implementation of decimalization has enabled the pricing

of securities in the United States to conform with securities markets around the

world. Most institutional traders, such as myself, are continually adjusting to the

new trading environment and we are already seeing the development of competitive

products to help us cope with the change.

Critics have contended that the problems that market participants are facing

since the move to decimalization have arisen solely as a result of that move. I do

not believe this to be the case. Instead, I would suggest that many of those problems

are the result of the underlying structure of the securities markets on which we

trade. Decimalization has simply brought these long-standing issues to the forefront,

thereby highlighting the urgency of addressing several unresolved market structure

issues. These include the need for the display of a meaningful depth of limit orders

by both specialists and market makers; the need for priority rules for orders entered

into the securities markets; and the need to address problems arising from the internalization of orders. I have long advocated that with the move to decimals, we

need greater transparency and increased electronic access to the floor. Since

decimalization, there are many more transactions, yet overall trading volume has

not been affected. Furthermore, the depth or amount of shares on the inside market

has been reduced.

I should note that most of the difficulties that I have faced since decimalization

have occurred while trading on the New York Stock Exchange (NYSE). In contrast,

we have had few such problems when trading securities on the Nasdaq Stock Market, due largely to the fact that electronic communications networks (ECN’s) have

offered efficient access and have allowed traders to deal in smaller increments while

at the same time retain control over order flow. The NYSE has taken some bold

steps to address these emerging market issues, including the implementation of the

‘‘Network NYSE,’’ a program that offers a limited degree of transparency and

connectivity for both institutional and retail customers. Furthermore, I commend

the Exchange for attempting to address some of the unintended consequences of

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decimalization by introducing two initiatives—Depth Condition and Depth Indicator—to increase transparency and improve the communication of market depth in

a decimal trading environment, and by allowing users to view the entire NYSE electronic limit order book.

Since the implementation of decimalization on the NYSE, the execution of large

orders has actually been hampered by the reduced transparency of orders on the

Exchange’s limit order book and by increased instances of market participants stepping ahead of orders by increments of as little as one penny. The net effect has been

for the institutional trader to lose control of his/her order flow, since no effective

tools exist in the NYSE listed market to reach the market efficiently. The ‘‘upstairs’’ trader does not have the time to negotiate trades as quotes change rapidly. This

lack of control has led the ‘‘upstairs’’ trader to expose less to the Market for fear

of being ‘‘front run’’ for a penny (See Attachment A). Examples such as this have

created a disincentive for market participants to enter orders of any significant size

into the Exchange. As a result, an increasing amount of order flow has left the Exchange and been directed to alternative markets where institutions face less of a

risk of having their orders stepped ahead, further fragmenting the listed market.

These problems are not due to decimalization. They result from the fact that the

NYSE does not provide sufficient protection to the orders that I—and other institutional traders—utilize in trading large amounts of stock. Today, when an electronic

order is sent to the exchange via Super Dot (an electronic order routing system that

links member firms to specialists’ posts on the trading floor,) the order is first exposed to the brokers on the floor who surround the specialists post prior to actually

interacting with the Limit Order book. This technique is called ‘‘an attempt at price

improvement.’’ If an electronic order is small, it may in fact receive price improvement. If, on the other hand, the electronic order is large, the specialist may first

allow the crowd to interact with the limit order prior to execution of the trade.

These hidden orders in the ‘‘pockets’’ of the floor brokers gain standing. When an

institution attempts to interact with limit orders on the book, most institutional

traders feel this exposure to the crowd is unnecessary. If the ‘‘upstairs’’ trader were

able to interact with the limit order book without delay, floor brokers might be compelled to make instantaneous decisions and not use limit orders as options. In order

to resolve these problems, institutions must have facilities for the automatic execution of large orders on the Exchange and the ability to trade large orders without

subjecting those orders to the price improvement mechanisms.

These remedies to the problems that institutions are facing were recently included

in a letter from the Investment Company Institute (ICI) to the NYSE, which I have

attached as part of my official statement (See Attachment B). In this letter, the ICI

recommends changes to the NYSE’s new system to facilitate the ability of institutional investors to trade large orders on the Exchange (‘‘Institutional Xpress’’). Specifically, the ICI recommends that large orders eligible for execution in that system

should not be permitted to be represented by specialists to the crowd on the floor

of the Exchange. In addition, the orders do not become expressible until it is on the

best bid or offer for a time period of 30 seconds. This should be changed, to enhance

efficiency, there should be no time limit. Institutional Xpress also requires that an

order be at least 25,000 shares in size—this number is too high. Furthermore, Institutional Xpress should be able to reach through the offer to get to the available liquidity pool. These are all significant concerns that must be addressed.

While the NYSE and the specialists will tell you that they are benefiting investors

by providing price improvement, I, along with my colleagues on the buyside (would

gladly forego this price improvement, which can be as little as a penny in a decimal

environment, to receive protection for our displayed orders. By making this change

to the Institutional Xpress system, the NYSE has the opportunity to promote the

placement of limit orders on the book by providing protection for, and rewarding the

placement of, those orders and attracting order flow. These improvements that I

suggest will serve to increase the depth and liquidity of the market. The changes

I suggest—both a stronger limit order book and greater transparency—will result

in enhanced liquidity for all users of the NYSE. Greater liquidity enables more costeffective execution. It follows that the more transparent the market is, the more

informed decisions an investor can make whether he/she is an institutional trader

or a retail customer.

In closing, I have directly worked with the NYSE and other exchanges for years

to voice my opinions—as well as competitors’—on how best to provide institutions

the liquidity to perform effectively on behalf of our clients’ portfolios. These changes

pose no threat to the NYSE, rather, these enhancements offer the ability for institutions and retail participants to transact efficiently and at the best price.

I thank you again for this opportunity to testify, and I am pleased to answer any

questions.

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1The SEC considered banning payment for order flow in 1993. Ultimately, however, and

wrongly, in our view, the SEC decided to permit it to continue so long as the practice was disclosed to brokerage customers whose orders were being sold. See SEC Release Nos. 34–33026

(October 6, 1993) and –34902 (October 27, 1994).

PREPARED STATEMENT OF ROBERT B. FAGENSON

VICE CHAIRMAN, VAN DER MOOLEN SPECIALISTS USA, LLC

VICE CHAIRMAN OF THE SPECIALIST ASSOCIATION OF THE NYSE

MAY 24, 2001

I am Robert B. Fagenson, Vice Chairman of Van der Moolen Specialists USA,

LLC, a New York Stock Exchange (‘‘NYSE’’) specialist firm. I appear before you

today in my capacity as a specialist.

On behalf of the Association, I want to express my thanks for this opportunity

to testify before the Subcommittee on the effects that ‘‘decimalization’’—that is,

changing the typical trading increment for securities from sixteenths to pennies— has had on our securities markets.

In April 1997, I had the pleasure of testifying before the House Subcommittee on

Finance and Hazardous Materials concerning H.R. 1053, ‘‘The Common Cents Stock

Pricing Act of 1997.’’ That bill, which was never passed, would have required the

Securities and Exchange Commission (‘‘SEC’’) to adopt a rule that would replace

trading in fractions with trading in decimals. The bill also would have left it to the

SEC to decide the minimum number of cents per share that should characterize bid

and offer quotations for stocks and last sale reports for those securities in our markets. The primary purpose of The Common Cents Act and the move to decimal trading was to reduce the ‘‘spread’’ between bid and offer prices for securities. The

spread was widely regarded as excessive and as a cost visited on public investors

that was not subject to the moderating force of competition. Creating more pricing

points in each dollar of stock traded (potentially one hundred compared to the sixteen that characterized traditional trading fractions in our markets), according to

theory, would enhance price competition among traders and thereby reduce spreads

and lower the costs that they represented. In short, fixed minimum fractional

spreads were said to punish investors and reward traders. A beneficial side effect

of eliminating fractional trading increments was supposed to be elimination of ‘‘payment for order flow,’’ a practice whereby a market maker or market pays money— a cent or more per share—to a broker to, in effect, ‘‘buy’’ that broker’s flow of customer orders.1

Imagining then that the worst that could happen as a result of a change to decimal trading would be a reduction in the trading increment to as little as a penny,

we predicted in 1997 the following:

1. We believed that decimalization and any consequent narrowing of spreads between bid and offer prices would reduce the profitability of payment for order flow

and internalization of retail orders in listed stocks. We think that this has occurred,

but not to such a degree as to eliminate either payment for order flow or internalization—both of which we regard as bad practices.

2. We thought that decimalization would tend to reduce the ability of regional

stock exchange specialists that trade NYSE stocks to do so. We also think that this

is happening.

3. We said that decimalization, especially if the trading increment was reduced

to a penny, would incent on- and off-floor market professionals to trade for their

own accounts ahead of customers by stepping in front of their orders by a single

penny. This, too, has happened. ‘‘Stepping ahead’’ has acquired a bad name in today’s markets even though it improves the price for the other side of the trade—

something that those who characterize the practice seem to forget, focusing only on

the disappointed would-be buyer or seller and not at all on the ‘‘improved’’ other

side of the trade. We observe that ‘‘stepping ahead’’ of (or ‘‘pennying’’) customers almost always seems to involve trading by market professionals, including institutional traders, rather than specialists and market makers, at least in the exchange

markets. Market professionals acknowledge that they engage in this practice, even

though they dislike it, because they believe that their responsibilities force them to

do so in a penny-increment trading environment.

4. We pointed out that decimalization would reduce transparency in our markets

by cluttering bid-offer quotation displays with short-lived bids and offers for small

amounts of shares that would flicker in and out of existence too rapidly to permit

public customers to take advantage of apparent price improvements. Further, we

said that the overall effect would be to make the actual prices of stocks more difficult to determine by increasing the number of trades displayed on the consolidated

54

tape at very small price changes. This prediction also has come true—and to an

even greater extent than we anticipated in 1997.

5. Finally, we predicted that, if spreads were significantly reduced, the sizes displayed to the markets in connection with prevailing bid and offer prices also would

be reduced. This, too, has occurred, and to a much greater degree than we foresaw

in 1997.

Collectively, we think that the most severe and adverse of the effects that have

been engendered by decimalization have been these:

1. The significance of the pricing information available to public investors and

market professionals—namely, last sale reports and displayed bid and offer

quotations—has been blurred. This is because, with one hundred pricing points are

available for each dollar of stock traded instead of the sixteen that existed when

we traded in fractions, stock prices now change much more rapidly, and because the

amount of stock available to be bought or sold at any single pricing point is much

smaller than was the case when fewer pricing points were available.

2. There has been a loss of predictable and visible liquidity at the prices of displayed bids and offers (in the form of quotes with size). This has happened because

interest in buying or selling is spread out among more of the possible pricing points

than was the case when there were fewer of them, and because, since only the highest bid and lowest offer in each market is widely disseminated, the degree of liquidity, or the lack of any liquidity, at prices away from the best bid and offer prices

is hidden.

3. There now is a trend toward trading in increments as small as 1⁄100 of a cent

or $.0001. So far, this phenomenon has been confined to trading in over-the-counter

(‘‘OTC’’) stocks, where visible liquidity is now significantly lower than it was in a

fractional trading environment. The adverse effects of such trading have been partially obscured by the fact that the NASD’s mechanisms for disseminating consolidated last sale and bid and ask information in OTC stocks are not yet capable of

showing prices in increments smaller than a penny. Display of actual four-decimal

place prices (or even smaller increments), we believe, would sharply amplify these

negative effects.

In our view, the foregoing factors indicate that trading stocks in penny increments

may have confused and disadvantaged public investors rather than helped them.

Spreads may have been reduced, but investors cannot put those ‘‘saved’’ spread increments in their pockets. Instead they find that, in a penny-trading environment,

even modestly sized buy and sell orders are sometimes broken into three or four

separate parts before they can be filled—and that those parts are filled at different

prices. In addition to getting different prices, this usually also involves increased

clearing costs for the customer. This did not occur when we traded in fractions. Before the change to decimals, orders of modest size did not move market prices away

from the levels that prevailed before those orders were entered in the market. These

costs, unlike the supposed savings inherent in ‘‘reduced spreads,’’ are readily understood by all.

How did we get to where we are from a well-meaning effort to make stock trading

more understandable and less expensive for the public? Most investors, we would

think, like everyone else, really would rather do away with pennies altogether,

rather than be forced to carry and use them—though we all do. No one at all, however, carries mills or tenths of mills in their pockets or can be expected to think

rapidly in terms of such units. Can it be said that a price of 101⁄4 is harder to understand than a price of $10.2639? We think not.

The Association believes that adjustments can be and are being made to overcome

the problems that have attended the movement from sixteen pricing points for each

dollar in fractional trading to one hundred such points in a penny trading environment. For example, investors are learning that the smaller sizes associated with

each such pricing point displayed as part of a quotation can be and often are quickly

exhausted, forcing prices to the next higher or lower level. As a result, investors are

finding that it makes sense to place a limit or ‘‘cap’’ on the prices they are willing

to pay or accept when they buy or sell and to confer discretion on their brokers to

work within the cap to fill their orders. This trading process, however, and the diminished liquidity available at any particular pricing point, may well result in average prices for investors above the lowest offer or below the highest bid displayed

at the time their orders were entered in the market.

Under these circumstances, are investors paying more to buy stock or getting less

when they sell stock than was the case before the introduction of decimal trading?

We have no data to support a conclusion in this regard. At the same time, because

sizes associated with displayed bids and offers seem to us to be so much smaller

than they were in a fractional trading environment, it is entirely possible that it

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has become more expensive, on the whole, for ordinary investors to transact than

formerly was the case.

Our final concern—reduction of the trading increment below one penny—is our

most serious one. Reduction of the trading increment below a penny, in our view,

could damage the integrity of the markets’ pricing function and undermine public

confidence in the fairness of our markets. This could occur because trading in tiny,

sub-penny increments will even more completely obscure the true state of the market as it is seen by individual and institutional investors alike, as liquidity at particular price points is buried beneath very small size amounts associated with

momentarily higher bids or lower offers. In turn, this effect can be expected to increase investor uncertainty as to the price at which a buy or sell order of any substantial size can be executed and to increase buyers’ and sellers’ anxiety that their

intentions will become known to the market before their orders can be filled. Last,

because of the spray of prices resulting from sales in increments smaller than a

penny, confidence that any particular price is ‘‘the’’ price at the moment will be

sapped.

Our securities markets are acknowledged by all to be the most powerful engine

for the raising of capital ever conceived. Risking the basic pricing and trading mechanisms of that engine and public confidence in them by allowing the uncontrolled

splintering of the prices at which stocks trade and in which bids and offers are

made is worse than foolish: it is dangerous.

For the foregoing reasons, we urge the Subcommittee to consider legislation that

would not only empower the SEC, but also require that agency, to determine appropriate trading increments for different categories of stocks (that is, actively or thinly

traded, highly capitalized or less robust, and so on) and to adopt an appropriate rule

that would compel the markets and broker-dealers to adhere to those increments

in the trading of securities. In 1997, we thought that it would not be necessary to

ask for government assistance to deal with the consequences of decimalization. Experience with decimals to date, however, has persuaded us that we were wrong and

that such assistance is badly needed now. We are unsure whether the SEC has authority today under the Securities Exchange Act of 1934 to adopt particular trading

increments. We are confident, however, that, with the help of the securities industry

and academicians, the SEC will be able to develop a rational limit on what now is

a dangerously uncontrolled process of endlessly splintering the trading increment.

I would be pleased to respond to questions.

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM

LAURA S. UNGER

Q.1. At the May 24, 2001, Subcommittee hearing I asked you about

the status of the Commission’s consideration of repealing or significantly revising the Short Sale ‘‘Uptick’’ rule. You stated that the

Commission would be coming out with a proposal shortly. I note

that the Commission’s semiannual regulatory agenda, published

May 14, 2001, in the Federal Register, states that the Commission

expects to publish a notice of proposed rulemaking (NPRM) on the

Short Sale Rule by the end of May 2001, which is this month.

Please clarify for the Subcommittee the Commission’s time frame

for issuing the NPRM.

A.1. We anticipate that the staff’s recommendations on possible revisions to Rule 10a–1 will be ready for the Commission to consider

by late summer.

Q.2. In addition, it is my understanding that several commenters

to the October 1999 SEC concept release on revision or repeal of

the Short Sale Rule believe that the rule should be repealed in its

entirety. Decimalization further reduces the economic justification

for retention of the Short Sale Rule. Is the SEC considering a repeal of the Short Sale Rule, or merely a revision to the rule?

A.2. As you note, the Commission in 1999 published a concept release seeking comment on Rule 10a–1. The concept release sought

comment on eight concepts related to the regulation of short sales

of securities, including eliminating Rule 10a–1. The comments received in response to the concept release were mixed. A few commenters (9 out of a current total of 2,577) advocated repealing the

rule altogether, while others favored retaining the rule with modifications. The majority of the comment letters were delivered electronically by individual investors calling for extending short sale

regulation to cover nonexchange listed securities, such as Nasdaq

Small Cap, OTC Bulletin Board, and Pink Sheet securities. The

staff is currently developing a proposal on the Short Sale Rule for

the Commission’s consideration. It would be premature to comment

in detail on what that proposal will be until the Commission has

had a chance to consider the staff’s recommendation.

The staff does intend, however, to recommend that any proposal

address the issue of decimalization. While the staff believes that it

may be premature to say that decimalization has further reduced

the economic justification for retention of the Short Sale Rule,

decimalization raises at least two other distinct questions regarding the operation of Rule 10a–1. The first is the extent to which

the reduction in the minimum price increment from 1⁄16 (6.25 cents)

to a penny makes it more difficult to comply with the rule, due to

rapid trade and quote price changes. The second question is, in a

decimals environment where price differences between trades can

be a penny (or less), how much above the last sale (or bid) should

a short sale be executed in order to achieve the goals of the rule.

The staff intends to recommend that the Commission inquire in the

proposing release regarding the effects of decimal-ization on the

Short Sale Rule and will recommend regulatory changes, as necessary.

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Any short sale proposing release will be designed to attract constructive input from a broad range of market participants, and will

encourage commenters to supply data to support their views. We

hope that these responses will assist our understanding of both the

costs and benefits of the current Short Sale Rule. We will study the

comments and any accompanying data to improve the regulation of

short selling.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI FROM

CATHERINE R. KINNEY

Q.1. At the May 24, 2001, Subcommittee hearing there was some

discussion regarding the SEC revising or repealing the short sale

uptick rule. The SEC indicated at the hearing that they will be

issuing a proposed rule on revising or repealing the Short Sale

Rule in the very near future. The consensus seems to be that the

Short Sale Rule should be scaled back, if not totally repealed. Do

you believe that the rule has any continued economic or policy justifications? If so please identify the market capitalization and trading volume thresholds, as well as other criteria, which you believe

are appropriate.

A.1. The New York Stock Exchange does not favor elimination of

the Short Sale Rule. We continue to believe that this rule provides

important safeguards in protecting the public interest and in maintaining an orderly marketplace. The rule continues to offer appropriate regulatory safeguards for allowing short-selling in a rising

market, while prohibiting short-selling from being used to accelerate a declining market. The elimination or modification of the

rule could have the effect of encouraging short-selling activities in

which the price of a security could be manipulated. We also understand that companies that have listed their securities on the Exchange favor the retention of the rule.

If the SEC issues a proposed rule to revise or repeal the Short

Sale Rule, the Exchange will comment on such a specific proposal

at that time.

Q.2. In your testimony, you indicate that price improvement on the

New York Stock Exchange has increased, particularly for smaller

orders. Please explain how the NYSE measures price improvement.

A.2. When placing a market order, there is an expectation that the

order will be filled at the current best bid or offer—for example, the

quote. The NYSE measures price improvement by comparing the

actual price with that quote. The statistics are further summarized

in categories by order size.

Published along with the quote is the number of shares available

to buy or sell at that price. When calculating price improvement

numbers, the NYSE does not include orders that exceed the published size. We do not calculate the statistics for stocks with a per

share price above $1,000, or stocks trading in round lots of less

than 100 shares, and we exclude odd lots from our calculations.

In May 2001, 47 percent of all orders executed on the Exchange

received price improvement. The Exchange publishes best execution statistics each month on our website, www.nyse.com.

Q.3. The Investment Company Institute, in a March 1, 2001, letter

to Mr. Grasso, Chairman of the New York Stock Exchange, has reVerDate 11-MAY-2000 08:40 Apr 30, 2002 Jkt 000000 PO 00000 Frm 00061 Fmt 6633 Sfmt 6601 78288.TXT SBANK4 PsN: SBANK4
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quested changes to the functioning of Institutional Xpress to ‘‘facilitate the ability of mutual funds and other institutions to trade

large orders on the Exchange.’’ What are the drawbacks, if any, to

implementing the changes requested in the letter, such as the 30-

second requirement and the automatic execution of large orders?

Would anyone be disadvantaged by these proposed changes?

A.3. We believe that some of the changes requested by the Investment Company Institute would increase volatility by diminishing

the ability of all orders to participate in the auction market. It is

important to have a mix of institutional and retail order flow in the

price discovery process, and to ensure that both institutional and

retail orders receive the best price through the same auction process. We need to gain experience with Institutional XPress, and we

will be reviewing the suggestions submitted by the ICI and other

market participants.

We have, however, taken some action in accordance with discussion in the Exchange’s initial rule filing for the approval of Institutional XPress. We stated at that time that certain changes were to

be considered within 6 months after the initial implementation of

the XPress product. On June 11, 2001, the Exchange filed with the

SEC a proposed rule change relating to Institutional XPress

quotations and orders. The rule filing proposes to reduce the minimum size of an XPress quote from 25,000 shares to 15,000 shares;

reduce the time period for designation as an XPress quote from 30

seconds to 15 seconds; and reduce the minimum size of an XPress

order from 25,000 shares to 15,000 shares. This current rule filing,

which has not yet been acted upon by the SEC, is in accord with

our previously expressed intention.

Q.4. During his testimony before the Subcommittee, Peter Jenkins

of Zurich Scudder Investments expressed some concern about trading on the NYSE. He mentioned that the one cent MPV has hampered the ability of institutional investors to obtain executions on

the NYSE floor, because market participants can step in front of

any order, for as little as one cent price improvement.

Mr. Jenkins testified that the problem institutional investors face

is due to the lack of control they can exercise over the trades they

send to the floor, for example, since trades are exposed to the floor

crowd, large institutional orders do not receive ‘‘sufficient protection’’ and can be broken up. Please respond to these comments by

Mr. Jenkins. In particular, please address whether the NYSE floor

specialists are the market participants who are stepping in front of

institutional investors’ large block trades.

A.4. While there may be a perception that specialists are stepping

ahead of customers at a minimally improved price (commonly referred to as ‘‘pennying’’), in fact a recent study shows that twothirds of such ‘‘one-tick-better’’ trades are by nonspecialists. The

vast majority (about 85 percent) of ‘‘pennying’’ quotes appear to

arise from system limit orders. The facts suggest that, contrary to

reports in the press and elsewhere, in the large majority of trades

NYSE’s floor specialists are NOT stepping in front of institutional

investors’ large block trades.

This study, ‘‘Getting ‘Pennied’: The Effect of Decimalization on

Traders’ Willingness to Lean On the Limit Order Book at the New

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York Stock Exchange,’’ is attached and can also be found on our

website, www.nyse.com.

Nevertheless, the NYSE has taken steps to assuage the concerns

of institutional investors. The NYSE has recently taken action to

address the ability of institutional investors to execute large transactions at a single price. In early June, our Board approved an

amendment to our Rule 72(b) to provide that a specialist may not

effect a proprietary transaction to provide price improvement to either side of a ‘‘clean cross’’ transaction. The proposed amendment

will preserve the auction market principle of price improvement

since orders sent in from off the trading floor and placed with the

specialist or a floor broker may offer price improvement at any

minimum variation. This proposed rule change was filed with the

SEC on July 2. The NYSE has taken these steps to reassure this

important segment of the market of the integrity of our floor-based

auction market.

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