SECURITIES

PRICING

Trading Volumes and

NASD System

Limitations Led to

Decimal-Trading

Delay

United States General Accounting Office

GAO Report to Congressional Requesters

September 2000

GAO/GGD/AIMD-00-319

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD/AIMD-00-319 Decimal-Trading Delay

B-285368

September 20, 2000

The Honorable Thomas J. Bliley, Jr.

Chairman, Committee on Commerce

House of Representatives

The Honorable Michael G. Oxley

Chairman, Subcommittee on Finance and

Hazardous Materials

Committee on Commerce

House of Representatives

The Honorable Edward J. Markey

Ranking Minority Member, Subcommittee on

Telecommunications, Trade, and Consumer Protection

Committee on Commerce

House of Representatives

This report responds to your April 27, 2000, request that we examine the

progress that the securities industry has made toward the implementation

of decimal pricing for U.S. stocks. The U.S. equity markets are the only

major equity markets in the world that still use fractional pricing and some

observers have projected significant savings to investors following the

implementation of decimal pricing.

In January 2000, the Securities and Exchange Commission (SEC) issued an

order requiring all stocks and options exchanges and the National

Association of Securities Dealers, Inc. (NASD), which administers the

Nasdaq Stock Market, Inc., to develop a plan that would ensure that

decimal trading would begin by July 3, 2000. However, in March 2000,

NASD officials announced that they would not be able to meet this

deadline. As a result of this announcement, SEC suspended the order

requiring the markets to implement decimal trading by July 3, 2000. On

August 28, 2000 after SEC issued a new order, a small number of stocks

and options began trading in decimal prices, and a new phased schedule

for the implementation of decimal trading was put into place. This

schedule called for all securities to be quoted and traded in decimals by

April 9, 2001.
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As agreed with your office, this report addresses the following questions:

(1) what were the specific reasons that the Nasdaq market was not ready

for the July 3, 2000, implementation date and how NASD’s decimal-trading

preparations compared with those of the New York Stock Exchange

(NYSE); (2) how SEC approached oversight of the securities industry’s

implementation of decimal trading and how this compared with its Year

2000 oversight effort; and (3) what challenges remain regarding

implementing decimal trading for the industry.

Although the Nasdaq market experienced a surge in trading volume in late

1999, its existing systems were able to process the resulting message

traffic. However, NASD was unable to meet the original July 2000

implementation date for decimal trading in stocks because the new system

it developed for quoting prices in decimals had insufficient capacity to

process the increase in trading volume. The primary reason that this

system’s capacity was insufficient was that it lacked the capability to use

multiple computers for processing. In addition, NASD’s volume

forecasting methodology does not adequately incorporate the volatility of

the trading on its market; thus, it lacks effective criteria for determining

whether its systems have sufficient excess capacity. In contrast, both

NYSE’s processing environment and approach for preparing for decimal

trading differed from that of NASD. NYSE reported being ready to trade in

decimal prices by the original July deadline. NYSE experienced lower

increases in its trading volumes than did the Nasdaq market, and its

officials indicate that they use a more flexible information technology

architecture that allows their exchange to more easily expand processing

capacity.

SEC’s approach for overseeing the securities industry’s implementation of

decimal trading was similar to the approach it used to oversee the

industry’s Year 2000 readiness efforts. As it did for the industry’s Year 2000

preparations, SEC assisted in the establishment of standards and set

progress deadlines for securities market participants. Also similar to its

Year 2000 oversight, SEC relied largely on industry participants to report

their own progress and has conducted some on-site examinations of

market participants’ preparations for decimal trading. Although SEC

conducted various reviews of NASD that raised capacity concerns, SEC

officials relied on NASD’s representations regarding its decimal-trading

preparations and did not identify in advance the system limitations that

caused NASD’s delay.

Results in Brief
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Various challenges remain for the industry as it progresses toward

implementing decimal trading for all securities yet to be converted to

decimals. Although decimal trading for a selected number of securities

began August 28, 2000, the securities industry must complete a phased

implementation of all remaining securities, including Nasdaq-traded

stocks, by April 9, 2001 in accordance with a revised order from SEC. As

part of this, data on how decimal trading is affecting information system

processing volumes, participant operations, and trading behavior are to be

analyzed before allowing additional securities to begin trading in decimals.

In addition, the options markets continue to make limited progress in

taking steps to reduce the message traffic volumes expected to result from

decimal trading and, as a result, intend to implement decimal trading with

higher minimum price increments than will be used for stocks. Additional

challenges for securities market participants may arise if all securities

listed on NYSE and the other regional exchanges begin trading in decimal

prices before such trading begins for Nasdaq-listed securities, but industry

participants indicated that various steps could be taken to address these

challenges.

This report includes recommendations to SEC regarding the need for

improvements in NASD systems capacity planning and SEC’s oversight of

NASD’s preparations for decimal trading. SEC and NASD provided

technical comments, which were incorporated into the letter as

appropriate. In its letter, SEC said that it would be taking action to

implement our recommendation that it ensure that NASD makes various

improvements to its capacity planning process and intends to consider our

recommendation that it conduct more on-site examinations of NASD. In

its letter, Nasdaq stated that its efforts to implement decimal trading were

on schedule; however, Nasdaq objected to our report’s characterization of

the way in which their capacity planning process accounts for market

volatility as a weakness because their techniques are standard for the

industry. However, although we agree that their trading environment

presents them with a more unique and challenging task than that faced by

other markets, ensuring that their volume forecasts better incorporate

their trading volume volatility is a key component for determining whether

their information systems will have adequate processing capacity. Nasdaq

also objected to our draft report’s characterization of the criteria they use

for assessing the adequacy of their system capacities as inconsistent; in

response, we revised our report to instead indicate that their current

criteria are not effective and refined the language in our recommendation

regarding the criteria needed.
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Decimal pricing for securities trading is expected to result in various

benefits for U.S. investors and U.S. securities markets. Trading in decimal

increments should result in smaller spreads between the prices at which

securities are bought and sold, which should produce savings for

investors. The securities industry, led by the Securities Industry

Association (SIA), has been preparing to implement decimal trading since

1998.

In March 2000, we testified on the progress the industry had made and the

challenges that it continued to face.1

At that time, we cited adequate

systems capacity as being the primary challenge to the timely

implementation of decimal trading. When decimal trading is implemented,

traders will be able to quote prices using an increased number of price

increments. Currently, securities prices are usually quoted in increments of

1/16 of a dollar in the United States, which provides 16 increments, but

quoting prices in pennies results in up to 100 potential increments. Having

additional price increments is expected to increase the number of price

quotes and executed trades, which will increase the amount of message

traffic that must be processed by securities market participants’

information technology systems. In our testimony, we noted that the

greatest increases in message traffic were likely to be experienced by the

Nasdaq market and the options markets.

To determine why the Nasdaq market was not able to implement decimal

trading by the initial SEC-ordered implementation date of July 3, 2000, we

interviewed and obtained extensive documentation from NASD officials

regarding their approach to implementing decimal trading and their

capacity planning efforts. In addition, we reviewed external consultant

studies on Nasdaq market capacity planning and technology and SEC

examinations of Nasdaq market information systems. To understand the

approach that NYSE used to ready its systems for decimal trading, we

interviewed officials and reviewed documentation relating to the

exchange’s information technology systems and capacity planning process.

To determine how SEC approached the oversight of the industry’s

implementation of decimal trading, we met with SEC officials and

reviewed orders, information technology guidance, and surveys and

examinations of industry participants. In addition to discussions with SEC

officials and file reviews, we also referred to our past work on SEC Year

1

Securities Pricing: Progress and Challenges in Converting to Decimals (GAO/T-GGD-00-96, Mar. 1,

2000).

Background

Scope and

Methodology
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2000 oversight2to compare the SEC oversight approach to decimals with

its approach to oversight of industry Year 2000 readiness. We also

interviewed SEC officials, representatives of securities firms, including

online broker-dealers; electronic communication networks (ECN);3

and a

representative of an investor advocate organization to obtain their views

on any challenges that remain as part of implementing decimal trading.

We also reviewed the comment letters that SEC received from securities

market, broker-dealer, data vendor, and other officials on the impacts of

beginning trading in all securities listed on NYSE and the other regional

exchanges before such trading began for all Nasdaq market securities.

We conducted our work in Washington, DC; Chicago, IL; and New York,

NY; between April and September, 2000, in accordance with generally

accepted government auditing standards.

NASD was unable to meet the July 3, 2000, SEC-mandated implementation

date for decimal trading because the system it developed to quote decimal

prices lacked sufficient capacity to process the trading volumes being

experienced by its market. In late 1999 and early 2000, the Nasdaq market

experienced unprecedented increases in trading and message traffic

volumes. In March 2000, NASD officials announced that the Integrated

Quote Management System (IQMS), which it intended to use to quote

prices in decimals, would not be capable of processing the message traffic

arising from this increased trading activity. However, IQMS’ capacity

could not be readily expanded because the initial version that NASD

developed was not capable of using multiple computers. In addition, IQMS

was written in a programming language that was less efficient than that

used for its existing quotation system. The capacity of IQMS also did not

prove to be as adjustable through programming changes as NASD

expected. Shortcomings in NASD’s approach to capacity planning also

contributed to its inability to meet the original decimal-trading

implementation date because it does not adequately incorporate the

increasing volatility in its trading volume and it lacks effective criteria for

determining whether its systems have sufficient excess capacity. In

contrast, NYSE, although experiencing less of an increase in trading

volume, has information technology systems whose capacity can be more

readily expanded and attempts to maintain a targeted level of excess

capacity. Rather than designing a new system, NYSE chose to primarily

2

SEC Year 2000 Report: Future Reports Could Provide More Detailed Information (GAO/GGD/AIMD98-51, Mar. 6, 1998).

3

ECNs are generally privately operated, screen-based electronic systems that allow customers to enter

orders that are displayed to other customers and executed as appropriate.

Insufficient System

Capacity and

Unprecedented

Trading Volumes

Delayed Nasdaq

Decimal Trading
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convert its existing systems to process decimal prices and reported having

made all necessary changes before the original July deadline.

In late 1999 and continuing into early 2000, the Nasdaq market experienced

an unprecedented level of trading activity. In 1993, the average number of

shares traded daily on the Nasdaq market was about 263 million.4By 1996,

the Nasdaq market’s average daily shares traded had increased to about

500 million. Beginning in 1997, trading volumes on the Nasdaq market

began to increase more rapidly, and it experienced a peak trading day of

over 1 billion shares in October 1997, as shown in figure 1. By 1999, trading

volumes on its market were averaging about 1 billion shares daily.

Subsequently, the Nasdaq market experienced an even more rapid increase

in trading activity. As can be seen in figure 1, this rapid increase in trading

began in the third quarter of 1999. The figure also shows that trading

volume on the Nasdaq market increased from an average of about 1 billion

shares a day during September 1999 to an average of 1.8 billion shares

during April 2000, which represents an 80-percent increase in 7 months.

NASD officials said that their market had never experienced growth at

such a high rate as occurred during this period.

4 Trades executed on the Nasdaq market usually involve securities firms, which act as market makers

for particular securities, buying from or selling shares to an investor. Thus, 100 shares being sold by

one investor and bought by another results in Nasdaq eventually reporting 200 shares as having traded.

This occurs because the market maker reports an executed trade when it buys the shares from the first

investor and also reports a trade when it sells the shares to the second investor. In contrast, executed

trades on the exchanges generally result from the direct matching of investors’ orders to buy or sell. As

a result, the Nasdaq market’s trading volume statistics may appear higher than those of the exchange

markets. Regardless, the information systems of the Nasdaq market are required to process the

message traffic resulting from the transactions between investors and its market making firms.

Nasdaq Trading Volumes

Increased Rapidly in Late

1999 and Early 2000
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Source: GAO analysis of data from NASD.

Overall, as its trading volume increased, the amount of message traffic

being processed by Nasdaq’s information technology systems increased

even more rapidly. As part of conducting trading activities, various

messages are sent through Nasdaq’s systems among the broker-dealers

acting as market makers in individual securities. These messages include

the price quotes at which they are willing to buy or sell securities,

customer orders, and reports of executed trades. As shown in figure 2

below, price quotation message traffic for the Nasdaq market has

increased substantially, increasing by over 1,121 percent between January

1997 and April 2000. In late 1999, the rate at which quotation message

traffic was growing increased even more rapidly on the Nasdaq market

because quotation traffic increased by 105 percent from September 1999 to

April 2000.

Figure 1: Average Daily and Peak Shares Traded on the Nasdaq Market, by Month (1997-2000)
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Source: GAO analysis of data from NASD.

The amount of message traffic that the Nasdaq market experiences for any

given level of trading volume has increased partly because of changes in

the way that trading on its market is conducted. Although trading volume

and message traffic volume are generally correlated, a market could

experience a peak in message traffic on a day that is not a peak trading

volume day. Conversely, a peak trading volume day may not result in peak

message traffic. According to NASD officials, a key reason its overall

message traffic has increased at an even faster rate than its trading volume

is because fewer shares are being bought or sold as part of each trade.

NASD officials attributed the decline in average trade size to an increase in

the number of individuals investing in stocks directly, the implementation

of the SEC Order Handling Rules,5 and the increased popularity of day

5

SEC’s Order Handling Rules required Nasdaq market makers to display customer limit orders and to

disseminate the best prices for orders placed by market makers in the trading systems operated by

ECNs.

Figure 2: Average Daily Quotation Messages on the Nasdaq Market, by Quarter (1993-2000)
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trading.6As shown in figure 3, the average trade size on the Nasdaq market

has consistently fallen since 1994, with about half as many shares being

traded per trade in 1999 as compared with the 1996 levels.

Source: NASD.

Although the trading volumes on the Nasdaq market have declined

somewhat since the high volumes it experienced in early 2000, market

participants expect trading volumes to continue to increase. After hitting a

peak of 2.88 billion shares on April 4, 2000, trading volumes on the Nasdaq

market averaged about 1.54 billion shares daily from April 5 until August 4,

2000. However, trading volumes are expected to increase and remain

volatile. For example, an external consultant7

that reviewed NASD’s

information technology systems said market volume growth and volatility

are likely to increase. NASD officials agreed that volumes on their market

were likely to continue to increase.

6

Day trading is a strategy that generally involves making multiple purchases and sales of the same

security during the day to profit from short-term price movements. See Securities Operations: Day

Trading Requires Continued Oversight (GAO/GGD-00-61, Feb. 24, 2000).

7

As a result of a January 2000 SEC report on Nasdaq’s information systems, SEC recommended that

NASD hire an external contractor to review NASD’s infrastructure capacity and its capacity planning

process. In response, NASD contracted with SRI/Atomic Tangerine to conduct this review.

Figure 3: Average Shares Per Trade on

the Nasdaq Market (1993-2000)
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Limitations in the capacity of the system that NASD developed to process

decimal prices resulted in its inability to meet the July 3, 2000, deadline for

implementing decimal trading. To disseminate price quotations across its

market, NASD has traditionally relied on a system that runs on a singlemainframe computer, and this system successfully processed the

unprecedented trading volumes that Nasdaq experienced beginning in late

1999. However, IQMS, which was the system that NASD was developing to

replace this older system, lacked sufficient capacity to process such

volumes and was not capable of having its capacity easily upgraded.

Although IQMS is currently being used to process quotations for some of

the trading being conducted on the Nasdaq market, NASD does not plan to

use it for decimal trading for the rest of its market and instead is readying

its older system to process decimal prices.

In contrast to NYSE and the other regional exchanges, the Nasdaq market

is a more widely distributed processing environment. To conduct trading

on the Nasdaq market, market makers located around the country enter

into the Nasdaq’s computer systems the prices at which they are willing to

buy or sell particular securities. These price quotations are consolidated

by NASD and displayed to all its members by one system; trades that are

based on these prices are executed through several other systems. NASD

officials told us that their various systems currently process around 3,000

messages per second (MPS). The system NASD currently uses to process

and disseminate price quotations across its market is known as its Legacy

System. This system has been in place since 1971 and was designed to run

on a single-mainframe computer. According to several external reviews of

NASD’s technology, Legacy has provided NASD with a very high level of

reliability and performance.

Although written to operate on a single-mainframe computer, NASD has

been able to upgrade Legacy to handle the increasing trading volumes and

volatility occurring on the Nasdaq market over the years. The mainframe

running Legacy has been replaced several times with more powerful

computers, and the latest upgrade resulted in NASD using the most

powerful machine currently made by this particular computer

manufacturer. In addition, NASD systems specialists have continuously

expanded Legacy’s capacity by making adjustments to its programming

software in a process called “tuning.” The hardware upgrades and its use

of the tuning process has allowed NASD to increase Legacy’s capacity by

almost 20,000 percent since 1972. During the increased surge in trading

volumes in late 1999, NASD officials reported being able to further

increase Legacy’s capacity by 77 percent during a 5-month period.

Nasdaq’s Decimal Price

Quotation System Lacked

Sufficient Capacity

Older NASD System Provided

High Level of Reliability and

Capacity Flexibility
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Although NASD’s existing systems have proven successful, the system

NASD designed to replace Legacy and allow it to process decimal

quotations was not capable of processing the trading volumes being

experienced by its market. IQMS is the system that NASD designed to

replace Legacy. According to NASD, the development work on IQMS

originally began in 1992, and it was expected to be implemented by 1994.

Unlike Legacy, IQMS is capable of processing price quotations in decimal

format, and NASD has used this system to process quotations for the

stocks traded on its Over The Counter Bulletin Board market8 since 1998.

NASD officials told us IQMS’ capacity was expected to be adequate to

process the message traffic associated with a 2-billion share trading day,

and, in 1992, Nasdaq’s trading volumes averaged about 200 million shares

daily. NASD officials indicated that, at that time, IQMS’ capacity was

projected to be greater than that of Legacy, but the continual tuning

adjustments have allowed NASD to greatly increase the older system’s

capacity. However, NASD experienced technical problems and other

delays in completing IQMS as originally scheduled. In some cases, NASD

was required to complete other technology initiatives, such as

implementing changes for the Order Handling Rules and readying its

systems for the Year 2000 date change. According to NASD’s Chief

Information Officer, as IQMS was being developed, the system designers

primarily focused on getting the system to function at the 2-billion shares

per day level and did not revisit the system’s capacity until June 1999. At

that time, they determined that such a capacity should still be adequate

because average trading volumes were not projected to exceed that level

for several years.

The primary reason that IQMS’ capacity was limited was that it lacked the

capability of performing processing across multiple computers. Using

multiple computers to perform processing is now commonplace among

organizations that rely on large-scale information processing because it

allows additional hardware to be added to systems as necessary to expand

capacity. However, NASD officials said that the initial version of IQMS was

designed to run only on the same single-mainframe computer as Legacy,

which it was to replace. NASD officials told us that they envisioned

eventually rewriting the software to allow it to process across multiple

computers or “load share.”

8

Stocks traded on the Bulletin Board are usually small companies with insufficient revenue or assets to

be listed on the Nasdaq’s primary market.

IQMS Designed With Capacity

Limitations
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Because securities trading volumes have generally increased over time,

developing a system with more flexibility in terms of capacity could have

led NASD to incorporate into IQMS the capability to load share as part of

its initial design. NASD officials told us that, at the time they first

considered the design of IQMS, they analyzed and tested two other

computer platforms that had load-sharing capability. However, according

to NASD officials, these platforms did not meet certain performance

requirements as well as the hardware that was used for Legacy and IQMS.

After conducting further testing of IQMS to determine its processing

capacity and considering the increasing Nasdaq market trading volumes,

NASD decided in June 1999 to develop a second version of IQMS.

This second version would have the capability of distributing processing

over additional computers and provide it with greater capacity than the

initial version. NASD officials indicated that they had previously

anticipated the need to create such a version of IQMS but had determined

that the system should first be implemented and proven to be operational

before being revised to allow load sharing. They also said that developing

an IQMS version capable of load sharing would be extremely challenging

because such distributed processing capability had not been accomplished

using this particular type of computer in a large-scale transaction

processing environment like that of the Nasdaq market. In addition, NASD

officials estimated that creating this version would require about 18

months; thus, it would not be ready on the original implementation date in

July 2000. Instead, NASD planned to use the first IQMS version to begin

decimal trading then and bring the second version with load-sharing

capability into operation later. However, as previously noted, the volumes

in the market grew too rapidly and NASD officials determined that,

although IQMS could handle the processing for a 2-billion share day,

implementing it without sufficient reserve capacity would have been too

risky in such a market environment.

NASD also selected a programming language that limited IQMS’ capacity.

Although IQMS was written using a more recent programming language

than used for Legacy, NASD officials told us that they determined that

IQMS requires more resources to process price quotations than would be

required by Legacy. The external consultant that reviewed NASD’s

capacity and systems development processes noted that NASD’s systems

developers used a programming methodology and language for IQMS that

were popular when the design of this system began in 1992. This

methodology used a programming language not commonly chosen for

systems today and also relied on prewritten programming modules to

perform certain standard functions. However, the external consultant
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indicated that such a methodology was an inappropriate choice for a

system that had to handle the large processing volumes on a real-time

basis as was necessary for IQMS.

IQMS’ capacity also proved to be less capable of being adjusted through

software adjustments. As previously noted, NASD was able to vastly

increase the processing capacity of Legacy through software tuning. In its

report on NASD’s capacity planning process, the external consultant noted

that NASD’s capacity requirement forecasts assume that it will continually

be as successful at increasing its systems capacities through tuning as it

has been in the past. NASD officials told us that they similarly expected to

be able to increase the processing capacity of IQMS through tuning once it

was operational. After testing, NASD estimated that IQMS’ capacity could

likely be improved by as much as 30 percent. However, the initial attempts

to tune the program produced improvements of only 3 percent, which

reflected the differences in the programming languages used in IQMS

compared with the language used by Legacy.

As a result of the capacity limitations in IQMS, NASD has had to take

several actions. First, NASD officials told us that, as of July 31, 2000, they

have begun using the initial version of IQMS to process the price

quotations for the exchange-listed securities that its members trade on its

market.9 This has allowed the Nasdaq market to process decimal price

quotations when such trading began for selected exchange-listed

securities.

To price quotations for its own Nasdaq-listed securities, NASD officials

intended to use the second version of IQMS that they had begun working

on in June 1999 that would be capable of sharing processing load across

multiple computers. However, NASD had also begun working on rewriting

the Legacy System to give it the capability of processing decimal

quotations. In May 2000, NASD decided to curtail further development of

the second version of IQMS. NASD officials said that they chose this

course of action because they could get better capacity performance with

Legacy than with IQMS. Because they will not be continuing to prepare

IQMS to process decimal quotations for trading for the rest of the Nasdaq

market, these officials expected that the rewriting of Legacy would be

complete during the first quarter of 2001 in time to meet the SEC’s planned

9

Securities listed by one exchange are also usually traded on other exchanges or markets. For

example, many stocks listed on NYSE are also listed and traded by the other regional exchanges, such

as the Pacific Exchange or the Chicago Stock Exchange. In addition, some members of the Nasdaq

market also make markets in exchange-listed securities. This trading of exchanged-listed securities on

Nasdaq is commonly referred to as the “Third Market.”

NASD Changed Its Approach to

Implement Decimal Trading
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implementation date. NASD also intends to implement a new system

sometime in 2001 that will replace Legacy, operate on multiple computers,

and have more advanced capabilities than its systems currently possess.

Shortcomings in NASD’s capacity planning process also contributed to its

inability to be ready for the original decimal-trading deadline. NASD uses

a forecasting methodology that has worked well in the past but does not

sufficiently consider the recent volatility in its market’s trading volume.

Moreover, it lacks effective criteria for ensuring that its systems have

sufficient excess systems-processing capacity, given its volatile market.

A shortcoming exists in the approach that NASD uses to forecast its future

trading and transaction volumes. NASD officials told us that they annually

develop forecasts of the trading volumes that are likely to be experienced

by the Nasdaq market over the next 3 years. The forecasting model used to

project trading volume is based on historical trading activity over the last

36 months. Using the output of this model, NASD forecasts estimates of

the expected average and peak transaction volumes. It also calculates a

likely range for these estimates, including a high-and-low expected value

for each estimate. These estimates are also updated monthly to account

for current market activity. According to these officials, this methodology

has been very successful, as NASD actual peak volumes have exceeded its

predicted values only twice in 20 years.

However, trading and message traffic volumes on the Nasdaq market have

become more volatile in recent years. As previously shown in figure 1,

trading volumes on Nasdaq began to be more volatile starting in late 1997.

For example, NASD officials said that the surge in trading activity in 1999

that prevented them from implementing decimal trading was

unprecedented, and, therefore, they had no basis to expect such trading

activity to occur.

However, according to the external consultant’s study of NASD capacity

planning, NASD’s forecasting methods, although standard for the industry,

do not adequately take into account this more recent volatility in the

trading activity on the Nasdaq market. In its report, this consultant

described a new technique that could potentially be used to improve the

forecast NASD produces of its expected trading volumes because it places

greater emphasis on more recent trading activity than does NASD’s current

methodology. The consultant’s report uses this technique to project NASD

volumes for 3 months into the future. However, NASD officials told us that

the technique in the consultant’s report would require additional

NASD Capacity Planning

and Systems Development

Does Not Adequately

Incorporate Trading

Volatility

Forecasting Methodology Does

Not Adequately Incorporate

Trading Volatility
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refinement to determine if it could be used to create forecasts of sufficient

length to be useful for systems capacity planning purposes.

NASD’s capacity planning process also lacks effective criteria for

determining whether the information systems it currently uses and those

under development have sufficient excess processing capacity. NASD

officials explained that they use the forecasts of expected transaction

volume to ensure that the actual processing capacities of their systems are

adequate to meet the highest level of these expected volumes, and they

have had considerable success using this method. However, NASD

officials acknowledged that they need to develop a better means of

assessing the adequacy of their systems’ processing capacities given the

increased volatility and rapid growth in their trading volume.

Developing criteria for assessing whether information systems have

adequate excess processing capacity is an increasing challenge for all

organizations active in the securities markets. The amount of excess

capacity in information technology systems can vary widely depending on

the type of processing that is required and the speed at which information

can be sent into such systems. The demands placed on systems used in

the financial markets can be particularly high as market conditions or

external news events can create unpredictable surges in trading volumes.

However, SEC officials told us that no standard criteria for making such

determinations currently exist for the securities industry. Some

organizations attempt to maintain excess capacity levels at set multiples

above their forecasted peak volumes. NASD officials indicated that they do

not use similar multiples of their forecasted peak, although they estimated

that they maintain levels of excess capacity that, at times, are comparable

to those of organizations that do use such targets. However, given the

volatility of their trading and the structure of their market, which can

result in more extreme surges in trading activity than usually occurs on

other markets, NASD officials said that the means they use to assess the

adequacy of excess capacity in their current and new systems will have to

more effectively reflect these differences. Having such criteria and

applying them during IQMS’ development may have also indicated the

capacity shortcomings of that system, such as when the Nasdaq market’s

trading volume peaked on October 28, 1997, with over 1.3 billion shares.

At that point, IQMS’ capacity was less than 2 times this peak.

Concerns had also existed that NASD’s capacity planning efforts had not

adequately taken into consideration the expected impact of decimal

trading on message traffic volumes. In April 1999, a study was completed

by SRI Consulting on behalf of SIA that estimated the impact that decimal

NASD Lacks Effective Criteria

for Ensuring That Its Systems

Have Sufficient Excess Capacity
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trading would have on industry information systems processing volumes.10

In its study, SRI projected that quotation volumes on the Nasdaq market

would increase by as much as 231 percent by year-end 2001 over their 1998

levels following the implementation of decimal trading if minimum price

variations (MPV) were a penny. In addition, in our March 2000 testimony,

we noted that SRI had revised its estimates upward in February 2000, to

project increases in quotation volume on the Nasdaq market as much as

700 percent by year-end 2001 from the 1998 levels due to increased market

trading activity.

NASD officials had initially indicated that the projections in SRI’s decimals

capacity study were not accurate for its market systems. Instead, they

indicated that their own research was more appropriate for estimating the

impact of decimal trading on their market. Using these projections, NASD

officials told us that they expected that their IQMS system would have had

adequate capacity to process the additional traffic resulting from decimal

trading. However, as previously noted, the growth in trading on Nasdaq’s

market exceeded expectations; thus, NASD had to postpone its

implementation of decimal trading. However, NASD has recently

contracted with SRI to produce forecasts of the impact of decimal trading

on the processing volumes for the Nasdaq systems that better incorporate

the specifics of their operations. NASD officials told us that these new

projections are much lower than the original study predicted. However,

we were not able to review the methodology and these results in detail

before the publication of this report.

SEC has also raised concerns over aspects of NASD’s capacity planning

process. According to an SEC official responsible for conducting

information system reviews, NASD has had capacity-related problems

since 1992. SEC has also noted these concerns in reviews done in recent

years. For example, in a 1997 review of Nasdaq market systems, SEC staff

expressed concerns about the ability of Nasdaq market systems to sustain

acceptable levels of service during periods of sudden and extreme surges

in transaction and quotation volume. At the time, SEC was anticipating

greater message traffic volumes on the Nasdaq market as a result of the

implementation of the Order Handling Rules, the advent of ECNs, and the

effects of smaller MPVs. According to NASD officials, they had developed

a plan and had begun to upgrade and expand their systems’ capacities to

address these concerns. In its report, SEC recommended that the Nasdaq

market accelerate these efforts, and NASD officials told us that they took

10 Assessing the Impact on Message Traffic of Trading Equities and Options in Decimal Increments, SRI

Consulting (Arlington, VA: Apr. 6, 1999).

SEC Has Also Raised Concerns

Regarding NASD Capacity

Planning Process
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various steps at that time to increase the capacities of their various

systems.

After conducting another review of NASD systems in the summer of 1999,

SEC issued a report in January 2000. In this report, SEC expressed

concerns that Nasdaq’s systems would not have sufficient capacity to

sustain acceptable service for current and projected levels of message

traffic, which were expected to further increase following the

implementation of decimal pricing. As a result of this concern, SEC

recommended that the Nasdaq market obtain an external review of its

capacity planning process that would be reported to the NASD governing

board by June 30, 2000. NASD received the final version of the report

completed by this external consultant in June and has been reviewing and

considering the study’s recommendations. Although the consultant

confirmed IQMS’ capacity limitations and NASD’s shortcomings in its

capacity planning, it also reported that NASD exceeded industry standards

in several areas, including systems reliability and in stress-testing

capabilities.

NASD has also undertaken various other improvements to expand its

system capacities. For example, NASD upgraded the capacity of its

enterprisewide communication network. In addition, NASD replaced the

mainframe computer it uses for quotation processing in October 1999 to

the largest unit offered by that manufacturer. NASD also implemented

new, multimessage switch architecture in the first quarter of 2000 that

doubled its message-switching capacity.

The processing environment differs for NYSE and its approach for

preparing for decimal trading also differed from that of NASD. According

to NYSE officials, their systems have been ready for decimals since April

2000, and NYSE was prepared to implement decimal trading by the initial

deadline of July 3, 2000. NYSE officials told us that their approach to

converting their systems for decimals was similar to the approach they

took for correcting Year 2000 flaws in their systems. They said that in most

cases, they programmed their existing trading systems to process decimal

prices, rather than creating new systems with decimal-trading capabilities,

which allowed them to ready their operations fairly quickly.

NYSE’s market structure, processing environment, and approach to

capacity planning also differs from that of NASD. With a widely distributed

network of market makers, NASD uses a single-mainframe architecture to

consolidate and process price quotations. In contrast, NYSE’s operations

are centralized on a single trading floor. NYSE officials told us that their

NYSE Had a Different

Approach to Readying Its

Systems for Decimals and

for Capacity Planning
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trading and quotations systems have used a computer architecture that

allows processing to be performed on multiple computers since about

1978. Such an approach allows NYSE to add additional computers, as

necessary, to expand capacity.

NYSE also uses various targets that are multiples of its current trading

volumes as criteria for ensuring that it has sufficient excess processing

capacity. In a June 2000 U.S. House of Representatives testimony, NYSE

reported that it can handle transaction rates of 1,000 MPS, which equates

to about a daily trading volume of 5 billion shares.11 NYSE officials said

that recent capacity modeling has indicated that their system’s maximum

capacities may be reduced below these levels, depending on how decimal

trading affects message traffic levels. By the end of the year, NYSE plans

to double its systems’ capacity to about 2,000 MPS. In contrast, the

Nasdaq market’s systems are reportedly already processing 3,000 MPS, and

NASD officials said that they plan to expand these rates to be 3 to 6 times

these levels.

NYSE’s systems development and capacity planning approach reflects its

experience with periods of high trading volumes. During the 1987 market

crash, high trading volumes occurred on NYSE, NASD, and the other U.S.

markets. All markets experienced problems in their information

technology systems, including NYSE.12 As a result, NYSE made various

changes, including expanding its systems’ capacities. During the recent

period of increased trading volume that began in late 1999, NYSE’s systems

performed as expected, although it did not experience as much of an

increase as the Nasdaq market. NYSE’s trading volume increased from

averaging about 780 million shares a day in September 1999 to an average

of 1.1 billion shares during March 2000, which represents a 45-percent

increase in 6 months. By contrast, average volumes on the Nasdaq had

increased by 80 percent during this period.

11 On Decimals 2000 - Will the Exchanges Convert?, Statement of Richard A. Grasso, Chairman and

Chief Executive Officer. Before the Subcommittee on Finance and Hazardous Materials, Committee on

Commerce, U.S. House of Representatives (June 13, 2000).

12 Stock Market Automation: Exchanges Have Increased Systems’ Capacities Since the 1987 Market

Crash (GAO/IMTEC-91-37, May 10, 1991).
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SEC has overseen the securities industry’s implementation of decimal

pricing using a similar approach to its oversight of the industry’s readiness

for the Year 2000 date change. As it did for that effort, SEC has primarily

relied on industry participants to report their readiness status and has

conducted on-site examinations of selected market participants. Although

SEC conducted various reviews of NASD that raised capacity concerns,

SEC officials relied on NASD’s representations regarding its decimaltrading preparations and did not identify in advance the system limitations

that caused NASD’s delay.

Within SEC, various groups are responsible for oversight of the securities

industry. Since 1991, SEC has had a small group within its Division of

Market Regulation that oversees information technology issues for the

exchanges, NASD, and clearing organizations. This group is responsible

for administering SEC’s Automation Review Policy (ARP). Under the ARP

program, SEC has issued guidance to the self-regulatory organizations

(SRO) in the industry regarding their information technology systems. This

guidance addresses various issues, such as capacity planning, systems

development, and information security. The guidance also indicates that

SEC expects SROs to have external reviews done of their information

systems. SEC did not initiate the ARP program under its rule-making

authority; thus, the program guidance is only voluntary for SROs.

SEC officials said that in addition to performing reviews related to this

guidance, SEC’s ARP group also monitors information systems issues at

SROs, including tracking changes to systems and reviewing rule filings

related to automation issues. The ARP group currently has a staff of eight,

all of whom have information technology backgrounds as well as other

training.

In addition to the SRO reviews conducted by the ARP staff in SEC’s Market

Regulation Division, other SEC staff also are involved in overseeing

information technology issues for the securities industry. SEC’s Office of

Compliance Inspections and Examinations (OCIE) conducts regular

reviews of broker dealers, investment advisers, and other market

participants on a variety of issues that sometimes address these firms’

information technology systems.

SEC’s Decimal-Pricing

Oversight Similar to Its

Year 2000 Approach

SEC Has Specific Group

That Reviews Information

Technology Issues
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As was the case in the industry’s preparations for the Year 2000 date

change, SEC’s initial efforts regarding decimal pricing involved increasing

awareness and assisting in establishing standards and approaches for

implementation. Beginning in 1997, SEC organized several meetings with

various market participants to address such issues as developing industry

standards and strategies for implementing decimal trading. For example,

these discussions addressed various topics, such as the appropriate

number of decimal places that information technology systems should be

capable of processing.

Similar to the milestones it set for its Year 2000 effort, SEC directed the

exchanges and NASD to take specific actions and established various

deadlines for the industry to meet as part of their efforts in implementing

decimal pricing. In September 1999, SEC issued an order to the

participants in the options markets requiring them to work cooperatively

on options quotation message traffic issues that are expected to arise as a

result of decimal trading.13 In January and June, 2000, SEC also issued

orders directing the exchanges and NASD to work together to prepare

implementation plans designed to ensure that the industry implemented

decimal trading according to the specific time frames designated in these

orders.14

As part of overseeing the securities industry’s Year 2000 efforts, SEC

required various market participants, including exchanges, broker-dealers,

and others, to periodically provide reports directly to SEC on the progress

of their efforts to ready their systems for the date change. SEC advised

broker-dealers that failure to adequately ready their system to correctly

process date-related information after January 2000 would be considered a

violation of the requirements for such firms to maintain accurate customer

records.

13 Application and Order Pursuant to Section 11A (a)(3)(B), Exchange Act Release Rel. No. 34-41843,

64 Fed. Reg. 50126 (Sept. 8, 1999). The order specifically applied to the American Stock Exchange,

LLC; the Chicago Board Options Exchange, Inc.; NYSE; the Options Price Reporting Authority; the

Pacific Exchange, Inc.; the Philadelphia Stock Exchange, Inc.; and the Securities Industry Automation

Corporation.

14 Order Directing the Exchanges and National Association of Securities Dealers, Inc., To Submit a

Decimalization Implementation Plan Pursuant to Section 11A(a)(3)(B), Exchange Act Release No. 34-

42360, 65 Fed. Reg. 5004 (Jan. 28, 2000) and Order Directing the Exchanges and the National

Association of Securities Dealers, Inc. To Submit a Phase-In Plan to Implement Decimal Pricing in

Equity Securities and Options Pursuant to Section 11A(a)(3)(B), of the Securities Exchange Act of

1934, Release No. 34-42914, 65 Fed. Reg. 5004 (June 8, 2000).

SEC Set Various Deadlines

for Decimal Implementation

and Surveyed Industry

Participants’ Readiness
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SEC has similarly required certain market participants to report on their

progress toward preparing for decimal trading. The ARP staff surveyed

the exchanges and NASD regarding their efforts to ready their systems to

accommodate decimal trading. These surveys were conducted in January

and July, 2000. To ascertain the readiness of broker dealers for decimal

trading, OCIE staff worked jointly with NYSE and NASD to prepare

surveys that SROs were to administer to their members.

In addition, SEC has also conducted examinations to review the readiness

of selected industry participants for decimal trading. To assess Year 2000

readiness, OCIE staff had initially conducted on-site examinations of

broker-dealer firms using a module containing a brief series of questions.

In 1999, it conducted a more detailed series of on-site examinations of

about 30 firms in conjunction with staff from various SROs. To review the

readiness of SROs themselves, ARP staff conducted on-site reviews that

also addressed Year 2000 issues as well as other matters of all SROs at

least once. During 1999, SEC also required SROs to submit monthly

surveys regarding their progress, and ARP staff used these to select SROs

for additional on-site examinations.

Regarding decimal trading’s implementation, SEC has also conducted an

on-site examination effort as it did to ensure Year 2000 readiness. To

assess the readiness of broker-dealers, SEC’s OCIE staff conducted on-site

examinations of a selected number of broker-dealers beginning in

February 2000. Since the new implementation date was established in

SEC’s June 2000 order, OCIE staff have again worked with SROs to plan a

joint series of examinations to follow up on the surveys administered by

the SROs. To conduct this effort, an SEC official told us that staff from

SEC, NYSE, NASD Regulation, and the Chicago Board Options Exchange

have jointly developed an examination module and participated in joint

training. These organizations plan to examine a total of 28 broker-dealers,

including a majority of the most active trading and clearing firms for

stocks and options. Corresponding to various checkpoints in the

industry’s phased implementation of decimal trading, the preliminary

results of these examinations are to be reported by mid-September, and

the final results are to be completed by late October. OCIE officials told us

that this effort has been modeled on the reviews conducted in 1999

assessing the Year 2000 readiness of large broker-dealers.

During 2000, SEC ARP officials told us that they have conducted

examinations that addressed decimal issues at 9 of the 14 SROs that must

ready their systems for decimal trading. These examinations were part of

the regular ARP inspections of these organizations’ information technology

SEC Also Has Conducted

Examinations of DecimalTrading Readiness
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and also address other issues beyond decimal-trading readiness. According

to an SEC official, fewer examinations have been conducted focusing on

decimal readiness because SEC’s resources were initially committed to

ensuring participants’ readiness for the date change in 2000, which they

viewed as a serious risk to market operations.

Although SEC has raised concerns relating to NASD’s systems capacities,

SEC staff relied on NASD officials’ representations about the progress

being made to ready the Nasdaq market’s systems for decimal trading and

did not identify in advance the system limitations that caused NASD’s

delay. As previously noted, SEC had conducted a recent examination of

NASD that addressed various aspects of NASD’s operations, including its

capacity preparations for decimal trading. This examination work was

conducted over a period of 8 days in July, August, and September, 1999,

and SEC issued the report that was based on this work in January 2000. In

its report, SEC expressed concerns about NASD’s systems capacity in light

of the likely increased volumes expected from decimal trading and

recommended that an independent review of NASD’s capacity planning

process be performed.15 In late February 2000, SEC received NASD’s

response to the first survey SEC had sent to all markets regarding their

decimal readiness, in which NASD indicated that its decimal efforts were

on schedule. However, within 2 weeks, NASD announced that it would be

unable to meet the expected implementation date of July 3, 2000.

Although the first phase of decimal trading began August 28, 2000, only a

small percentage of securities were converted to decimals, and various

challenges remain for the industry as part of implementing such trading for

all securities. As required by SEC, the relevant participants submitted a

plan for implementing decimal trading. During the phased-in

implementation outlined in this plan, the participants are to collect and

analyze information on (1) the effects of decimal trading on industry

participants’ systems operations and (2) the functioning of market rules to

ensure that the industry is ready for the next phase in the implementation.

The options exchanges will have to continue to work on addressing the

capacity concerns facing their markets. Finally, market participants will

have to prepare to mitigate the effects on the markets if the decimal

trading of all exchange-listed securities begins before such trading for

Nasdaq market securities.

15 We discussed the results of this SEC report in the previous section relating to NASD.

Industry Faces Various

Challenges in

Preparing for Decimal

Trading
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In June 2000, SEC issued its latest order16 that required the securities

exchanges and the Nasdaq market to prepare a plan to begin implementing

decimal trading by September 5, 2000.17 SEC’s order also required that

such trading be implemented for all securities by April 9, 2001. On July 24,

2000, the relevant market participants submitted the industry’s

implementation plan to SEC in response to the SEC order. As shown in

figure 4, the industry plans to implement decimal trading over four phases.

The first phase, which involves the trading of a limited number of

exchange-listed securities, began on August 28, 2000. As indicated in the

figure, in November 2000, the market participants intend to consider

allowing all exchange-listed stocks and their corresponding options to

begin trading in decimals while Nasdaq market stocks are trading in

fractions. If approved, such trading would begin 30 days later in

December.

16 Order Directing the Exchanges and NASD to Submit a Phase-In Plan to Implement Decimal Pricing in

Equity Securities and Options Pursuant to Section 11A(a)(3)(B), Exchange Act Release No. 34-42914

(June 8, 2000).

17 Named as “Participants” in the order were the American Stock Exchange, LLC; Boston Stock

Exchange, Inc.; Chicago Board Options Exchange Inc.; Chicago Stock Exchange, Inc.; Cincinnati Stock

Exchange, Inc.; International Securities Exchange, LLC; National Association of Securities Dealers,

Inc.; NYSE; Pacific Exchange, Inc.; and Philadelphia Stock Exchange, Inc.

Industry Participants Are

Preparing to Implement

Decimal Trading
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Phase 1

August 28

Decimal trading begins for approximately

10 to 15 exchange-listed securities and

options.

Minimum price variation (MPV) for stocks

would be set in pennies.

MPV for options priced above $3 will

be quoted in dimes; those priced below

$3 will be quoted in nickels.

2000

Phase 2

September 25

An additional 50 to 100 exchange-listed

securities with decimal prices are to begin

trading.

Figure 4: Planned Phases for

Implementation of Decimal Trading
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2000 2001

April 9

Phase 4

All securities to be priced in decimals.

Phase 3

March 12

Approximately 10 to 15 Nasdaq securities are

to begin trading with decimal prices.

Phase 2

November 1

Participants are to decide if all remaining

exchange-listed securities should begin

trading with decimal prices.

Source: GAO analysis of securities market participants’ plan for decimal implementation.

As part of implementing decimal trading under this phased-in approach,

the plan submitted by the securities market participants indicates that they

intend to collect and analyze information during the various phases. This

information is to be used to determine how decimal trading is affecting the

operations of participants’ information systems, including the impact on

these systems’ capacities. In addition, the participants intend to determine

how the implementation of decimal trading has affected trading behavior,

and this information is to be used as the basis for determining if any

changes to exchange or market rules are required. Before the beginning of

each subsequent phase of the implementation, the market participants will

convene and determine whether the industry is ready to begin the next

phase. Overall, the industry’s plan indicates that at a minimum of five

points in time, its representatives expect to confer with SEC about their

readiness to proceed to the next phase.

As we testified in March 2000,18 the options markets have faced a

considerable challenge in preparing for decimal trading. The system that

transmits the options market quotations, which is administered by the

Options Price Reporting Authority (OPRA), had experienced a peak of

about 3,500 MPS as of August 8, 2000. Efforts are under way to expand the

OPRA system’s capacity to 12,000 MPS by December 2000. However, the

consultant that performed the capacity study for the industry indicated

18 GAO/T-GGD-00-96.

Options Markets Have Made

Limited Progress on Capacity

Issues
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that options message traffic could reach 38,000 MPS by the end of 2001

after decimal trading is implemented.

Because of the potential that the message traffic arising from decimal

trading could exceed the OPRA system’s capacity, the implementation plan

submitted by the various market participants maintains minimum price

increments for options trading of between 5 and 10 cents, depending on

the price of the underlying stock. These increments are higher than those

for stocks, which will trade in penny increments. If lower increments were

used, the OPRA system would not have sufficient capacity because too

many quotation messages would be automatically generated by the

computers that options market makers use to produce their options price

quotes.

In response to the concerns over the OPRA system’s capacity, the various

options markets have also been cooperating with one another to develop

strategies for reducing message traffic levels. However, these efforts have

made limited progress to date. Currently, the options markets participants

have agreed to allocate the capacity of the OPRA system among

themselves during peak periods. This allocation is based primarily on the

historical peak volume of each market.

However, SEC has urged the options markets to develop a more equitable

allocation method. Using an allocation that is based on historical peak

volume results in more allocation being awarded to exchanges that

historically produced more quotations, regardless of whether these

quotations lead to actual trades. Therefore, SEC has sought comments on

its own alternative means for allocating the OPRA system capacity during

peak usage periods.19 The alternatives that SEC proposed are designed to

provide incentives for the options markets to reduce excessive quoting and

would reward those exchanges that quote more efficiently with a larger

allocation of the total transmission capacity of the OPRA system.

19 Proposed Rule: Options Price Reporting Authority; Proposed Amendments to National Market

System Plan. Release No. 34-42755; File 4-434 (May 4, 2000).
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Although acknowledging that securities listed on NYSE and the other

regional stock exchanges could begin decimal trading before those listed

on the Nasdaq market, the market participants that responded to SEC’s

request for comments, generally did not support such an approach. The

primary issues they raised included investor confusion, systems capacity

concerns, and increased potential for order entry and other errors.

However, market participants also indicated that steps could be taken to

mitigate these concerns.

After NASD announced it’s inability to meet the originally scheduled July

2000 date, some proponents called for decimal trading in all exchangelisted securities to proceed even though NASD would not be ready to begin

such trading in its own listings until the first quarter of 2001. In seeking

market participant input on the revised decimal-trading implementation

milestones, SEC referred to such trading as “dual pricing.” Although some

trading of exchange-listed securities is also conducted by NASD market

makers using NASD systems, NASD officials have indicated that the

systems used for such trading could be decimal-ready by September 2000,

which would allow dual pricing for exchange-listed and Nasdaq securities

to begin.

The securities industry market, broker-dealer, data vendor, and other

officials that provided written comments to SEC, and those that we

interviewed, generally acknowledged that it would be technically feasible

to begin trading in exchange-listed securities using decimal prices before

such trading began for those securities listed by Nasdaq. However, many

participants indicated that if a dual-pricing approach is implemented,

trading in the same security in both fractional and decimal prices should

be avoided. This concern arises because some securities are traded on

more than one exchange or market. According to these officials, the

reasons that such trading should be avoided included arbitrage on the

basis of different price increments,20 investor confusion, and the

prevention of industry systems processing limitations. The potential for

problems arising from having the same security being traded in both

fractional and decimal increments has been reduced as NASD officials

have indicated that the systems that it uses to support the decimal trading

of those exchange-listed securities traded on its market are currently

decimal-ready.

20 Arbitrage is the practice of buying securities in one market and simultaneously selling them in

another market to take advantage of a difference in price quotations between the two markets.

Steps Could Be Taken to

Address Challenges of

Implementing Decimal

Trading for Exchange-listed

Securities Before NASD

Listings
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Although acknowledging that decimal trading for all exchange-listed

securities could begin first, most industry participants raised various

issues with such an approach. The most frequently cited issue was that

having all exchange-listed securities trade in decimals while those listed on

the Nasdaq market traded in fractions would be too confusing to investors.

However, two data vendors and two ECNs we spoke with indicated that

investor confusion was not likely to be a major problem. For example,

officials from one of the ECNs told us that decimal pricing instead should

reduce confusion because it is a more rational pricing format and is used

in other world markets.

To address possible investor confusion, some market participants

suggested that an educational campaign for investors addressing decimal

trading in a dual-pricing environment would be required. SIA officials

advised SEC that educating investors about dual pricing would require a

major campaign. SIA has already developed various literature and press

release language that it plans to issue and that can be used by other market

participants to help educate their own customers about the transition to

decimal trading.

Some market participants also opposed rapidly moving to a dual-pricing

environment in the securities markets because of concerns over whether

information technology systems would have adequate capacity. For

example, the Chicago Board Options Exchange commented to SEC that

the impact of decimal trading on systems capacity was likely to be

enormous. Therefore, the Chicago Exchange warned that moving too

quickly to having all exchange-listed and Nasdaq securities trading with

dual pricing would (1) prevent the industry from measuring the impact of

decimal trading in a controlled environment and (2) reduce the exchange’s

ability to take remedial actions before its systems were overwhelmed.

Officials from the Securities Industry Automation Corporation, which is

the organization that performs information system processing for NYSE,

the American Stock Exchange, and the systems that link the stock and

options markets, told us that the industry already is facing a considerable

challenge in addressing increased trading volumes. As a result, they

suggested that waiting to implement decimal trading for all securities until

2001 could provide all market participants with more time to better

prepare for the additional volumes expected to result from decimal

trading.

However, as previously discussed, the industry plans to implement decimal

trading in phases and does not envision allowing all exchange-listed

securities to trade in decimals until December 2000 or later, thus reducing
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the length of time during which the markets would be trading under dual

pricing. This additional delay in implementing such trading would provide

more time for market participants to increase the capacities of their

information systems. In addition, the industry’s plan described above also

envisions analyzing the impact of decimal trading on market participants’

information systems capacities as part of determining whether to move to

the next phase of the implementation plan.

Market participants also expressed concerns that a dual-pricing approach

would increase order entry and other operational errors. One broker

dealer firm indicated that dual pricing would be confusing for its traders,

and that errors made as a result of dual pricing would affect customer

confidence. One particular area in which participants indicated that dual

pricing could increase errors involved investors’ entering orders through

on-line trading systems.21 For example, a broker-dealer firm commented to

SEC that investors may experience problems in conducting trades if they

use the wrong pricing format for an order that is later rejected by the

market for that security.

Although a dual-pricing trading environment could potentially increase

operational errors, some steps could be taken to reduce their occurrence.

For example, broker-dealers that accept customer orders using on-line

trading systems could program these systems to immediately inform

customers entering orders if they use an incorrect pricing format.

Although most participants expressed concerns about an approach

involving dual pricing for all securities, some indicated that having decimal

pricing begin for exchange-listed and other securities as soon as possible

would accelerate the benefits anticipated to result from decimal trading.

These officials indicated that rapidly implementing decimal trading would

reduce the delay in realizing the reduced spreads and other benefits to

investors expected from decimal trading. However, some participants

noted that investors would receive the greatest benefit when all Nasdaq

securities are trading in decimals because most trades in exchange-listed

securities do not involve the payment of a spread to a broker-dealer.

21 For additional information, see On-Line Trading: Better Investor Protection Information Needed on

Brokers’ Web Sites (GAO/GGD-00-43, May 9, 2000).
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Although the Nasdaq market experienced an incredible surge of trading

volume beginning in late 1999, it was able to process the resulting

increased volumes with its existing systems. However, the system NASD

developed to process decimal prices for its market had insufficient

capacity to process the trading volumes the market was experiencing. The

primary limitation affecting the capacity of this system was its inability to

use multiple computers to conduct processing.

In recent years, trading and message volumes on the Nasdaq market have

grown substantially and have become more volatile. However, NASD’s

methodology for forecasting such trading volumes and message traffic has

not changed to reflect the increasing volatility of this trading. As a result

of this new environment, NASD officials acknowledged the need to

develop better criteria for determining whether their information systems

have sufficient excess capacity in light of their market’s trading volatility

and how quickly they can expand processing capacity. If NASD had such

criteria and applied it during the development of IQMS, the capacityrelated limitations of this system may have been apparent earlier, such as

when it experienced a peak trading day in 1997 with volume exceeding 1

billion shares.

SEC has overseen the securities industry’s progress toward implementing

decimal trading using an approach similar to the way it oversaw the

industry’s efforts to prepare for the Year 2000 date change. As it did for the

Year 2000 effort, SEC relied largely on industry participants to report their

progress in readying their systems for decimal trading but also conducted

examinations of various market participants regarding their readiness for

decimal trading. In conducting its oversight of NASD, SEC generally relied

on NASD’s representations of the progress being made to ready that

market’s systems for decimal trading. However, SEC did not determine in

advance that NASD’s systems development efforts would not successfully

produce a system that would have adequate processing capacity for

decimal trading in time to meet the original implementation deadline.

Given NASD’s recent decision to modify its existing Legacy System to

accommodate decimal pricing, additional on-site examinations of its

progress on this revised strategy appear to be warranted. On-site

examinations could provide SEC with greater assurance about the specific

steps NASD is taking to implement decimal trading in accordance with the

SEC-mandated plan, including allowing it to better ensure the validity of

representations made by NASD officials.

Conclusions
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Although decimal trading has begun for a small number of securities,

various challenges remain for the securities industry as part of fully

implementing such trading for all securities. The industry participants have

a revised schedule to meet and all securities and all markets are to be

trading in decimals by April 9, 2001. Over the course of the phased

implementation, the market participants will also have to collect and

analyze sufficient data to assure themselves and SEC that the industry is

ready for each subsequent phase. This analysis is to ensure that market

participants’ systems have adequate processing capacity and are operating

properly. In addition, the participants will have to assess whether market

regulations are still functioning as intended in the trading environment

involving decimal prices.

We recommend that the Chairman, SEC, take steps to ensure that NASD

develops

• a volume forecasting methodology that better incorporates the volatility of

the Nasdaq market’s trading environment,

• systems that are capable of being quickly expanded to handle increased

processing levels, and

• criteria for determining the minimum amount of excess capacity to be

maintained for both existing and planned information technology systems

that adequately consider its market’s trading volatility and speed at which

its systems’ capacities can be expanded.

The Chairman should also direct SEC staff to conduct more on-site

examinations of NASD as a means of collecting and verifying additional

information on that market’s progress in implementing decimal trading in

accordance with the current implementation schedule.

We requested comments on a draft of this report from the heads, or their

designees, of SEC and NASD. These organizations provided us with

written comments, which appear in appendixes I and II, and also with

additional technical comments that were incorporated into this report as

appropriate.

In its letter, SEC described the role it has played in supporting and

overseeing the industry’s progress. SEC stated that our recommendations

regarding NASD’s systems capacity planning processes were consistent

with issues SEC has identified relating to NASD’s systems capacities. To

address this portion of our recommendation, SEC said they would review

the consultant’s recommendations to NASD and track NASD’s

implementation of these recommendations. As long as this results in

NASD making the improvements to their volume forecasting and systems

Recommendations

Agency Comments and

Our Evaluation
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development processes called for in our recommendation, this appears to

be a reasonable approach.

SEC said it intends to consider our recommendation that it conduct more

on-site examinations of NASD’s decimal-trading efforts, but noted that we

did not identify what additional information could be obtained through

more on-site examinations of NASD. In its letter, SEC acknowledges that

on-site examinations are an important element of its ARP program but that

it does not primarily rely on them, and it questions whether such an

approach would be an effective use of government resources. Although

we understand the approach SEC has taken with its ARP program, we

believe that there are benefits to be gained from additional on-site

examinations of NASD. As we noted in this report, although SEC

conducted some examinations of the Nasdaq market’s readiness for

decimal trading, it also relied on NASD officials’ representations of their

organization’s progress as part of its efforts to monitor NASD’s readiness.

Such representations indicated that NASD’s decimal-trading

implementation efforts were on schedule up until the public

announcement that it would not be ready.

On-site examinations would provide SEC opportunities to verify,

corroborate, and more thoroughly evaluate NASD’s progress and

readiness. As noted in our published auditing standards,22 evidence

obtained through direct physical examination, observation, computations,

and inspection is more competent than evidence obtained indirectly.

Regarding SEC’s concern over whether additional examinations would be

an effective use of government resources, the amount of resources

required to complete such examinations should be minimal and likely

assist in their oversight efforts to a greater degree than activities currently

being undertaken by SEC staff. Nevertheless, to address SEC’s comments,

we have modified our conclusions and recommendation to more

specifically discuss what we believe SEC would gain from conducting such

examinations.

In its letter, NASD stated that the efforts it is making to implement decimal

trading are on schedule. NASD also stated that our report incorrectly

characterized as a weakness the way in which its capacity planning

process accounts for the volatility of trading volumes on its market. It

indicated that referring to this as a weakness implies that it can be

remedied, but it stated that accurately predicting the future is notoriously

difficult for any organization. NASD further noted that it uses techniques

22 Government Auditing Standards, United States General Accounting Office, June 1994.
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standard for the industry but faces a harder task because its market has

experienced greater volume growth and greater volatility than other

markets.

We agree that the trading environment and market conditions of the

Nasdaq market present a difficult challenge for NASD in developing

accurate forecasts of its future trading volumes and accompanying

message traffic loads. However, ensuring NASD’s continued operations

will require it to enhance the techniques it employs to better account for

the circumstances of its market. Our report describes a possible technique

developed by the external consultant that reviewed NASD’s capacity

planning process that may serve as the basis for incorporating its market’s

trading volume volatility into its methodology for projecting future

volumes. We also acknowledge that this technique will require further

development before it could be used to generate forecasts of sufficient

length to be useful to NASD. In exploring this area, NASD may find that

some other techniques may prove even more applicable. Nevertheless, the

soundness of its market operations depends in part on being able to more

accurately forecast future trading volumes so as to ensure that it has

adequate processing capacity to accommodate such trading activity and,

as discussed in the next paragraph, to assist in identifying an adequate

level of excess capacity to maintain.

In response to our recommendation that NASD develop consistent criteria

for determining how much excess processing capacity to maintain, NASD’s

letter stated that the criteria it currently uses to size its systems are

consistent. It indicated that, instead, its shortcoming could be addressed if

it developed a method for calculating the need for excess capacity that

incorporates its market trading volume volatility with the capabilities of its

system architecture. We agree that the methodology that NASD officials

described to us is consistent, and we have revised the text of this report to

indicate instead that NASD lacks effective criteria for ensuring that its

systems have sufficient excess capacity.

We have also revised the language of the recommendation to indicate the

need for NASD to develop criteria that consider its market trading

volatility and the speed at which its systems’ capacities can be expanded

as discussed in a September meeting with NASD officials. As previously

noted, NASD faces a considerable challenge in predicting its future trading

volumes and implementing systems that can accommodate the growth and

volatility of its market. The criteria that NASD uses to assess whether it

has sufficient excess capacity in its systems will have to reflect the

increasingly volatile nature of its market’s trading. In addition, the
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flexibility and speed at which NASD can expand its systems’ processing

capacities will also affect the criteria that it develops. Using the lessflexible mainframe architecture on which it has traditionally relied for

processing price quotations will require NASD to plan for larger amounts

of excess capacity because expanding the capacity of such architecture is

more expensive and requires more time. As NASD transitions to

architectures that are more readily capable of using multiple computers to

perform processing, the need for larger amounts of excess capacity will

likely be reduced.

As agreed with you, unless you publicly release its contents earlier, we

plan no further distribution of this report until 30 days from its issue date.

At that time, we will provide copies to Representative W.J. “Billy” Tauzin,

Chairman, Subcommittee on Telecommunications, Trade, and Consumer

Protection, House Committee on Commerce; Representative John D.

Dingell, Ranking Minority Member, House Committee on Commerce;

Representative Edolphus Towns, Ranking Minority Member,

Subcommittee on Finance and Hazardous Materials, House Committee on

Commerce; appropriate congressional committees; Arthur Levitt,

Chairman, SEC; Frank G. Zarb, Chairman and Chief Executive Officer,

NASD; and Richard A. Grasso, Chairman and Chief Executive Officer,

NYSE. We will also make copies available to others on request.

Key contributors to this report are acknowledged in appendix III. If you

have any questions, please call Thomas M. McCool at (202) 512-8678.

Thomas M. McCool

Director, Financial Institutions

and Markets Issues

Keith Rhodes

Director, Computer and Information

Technology Assessment
Page 35 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
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Contents

1 Letter

Appendix I 38

Comments From the

Securities and

Exchange Commission

Appendix II 43

Comments From the

Nasdaq Stock Market,

Inc.

Appendix III 46

GAO Contacts and

Staff

Acknowledgments

Related GAO Products 48

Figure 1: Average Daily and Peak Shares Traded on the

Nasdaq Market, by Month (1997-2000)

7

Figure 2: Average Daily Quotation Messages on the

Nasdaq Market, by Quarter (1993-2000)

8

Figure 3: Average Shares Per Trade on the Nasdaq

Market (1993-2000)

9

Figure 4: Planned Phases for Implementation of Decimal

Trading

24

Figures
Contents

Page 37 GAO/GGD/AIMD-00-319 Decimal-Trading Delay

Abbreviations

ARP Automation Review Policy

ECN electronic communication network

IQMS Integrated Quote Management System

MPS messages per second

MPV minimum price variation

NASD National Association of Securities Dealers

NYSE New York Stock Exchange

OCIE Office of Compliance Inspections and Examinations

OPRA Options Price Reporting Authority

SEC Securities and Exchange Commission

SIA Securities Industry Association

SRO self-regulatory organization
Appendix I

Comments From the Securities and Exchange

Commission

Page 38 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix I

Comments From the Securities and Exchange Commission

Page 39 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix I

Comments From the Securities and Exchange Commission

Page 40 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix I

Comments From the Securities and Exchange Commission

Page 41 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix I

Comments From the Securities and Exchange Commission

Page 42 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix II

Comments From the Nasdaq Stock Market,

Inc.

Page 43 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix II

Comments From the Nasdaq Stock Market, Inc.

Page 44 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix II

Comments From the Nasdaq Stock Market, Inc.

Page 45 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Appendix III

GAO Contacts and Staff Acknowledgments

Page 46 GAO/GGD/AIMD-00-319 Decimal-Trading Delay

Thomas J. McCool, (202) 512-8676

Cody J. Goebel, (202) 512-7329

In addition to those named above, Davi D’Agostino, Daniel Goldstein,

Edwin Lane, and Jean-Paul Reveyoso made key contributions to the

report.

GAO Contacts

Acknowledgments
Page 47 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Related GAO Products

Page 48 GAO/GGD/AIMD-00-319 Decimal-Trading Delay

On-Line Trading: Better Investor Protection Information Needed on

Brokers’ Web Sites (GGD-00-43, May 9, 2000).

Securities Pricing: Progress and Challenges in Converting to Decimals (TGGD-00-96, Mar. 1, 2000).

Securities Operations: Day Trading Requires Continued Oversight (GGD00-61, Feb. 24, 2000).

Year 2000: Financial Institutions and Regulatory Efforts to Address

International Risks (GGD-99-62, Apr. 27, 1999).

Securities Market Operations: The Effects of SOES on the Nasdaq Market

(GAO/GGD-98-194, Aug. 1998).

Securities Pricing: Actions Needed for Conversion to Decimals (T-GGD-98-

121, May 8, 1998).

SEC Year 2000 Report: Future Reports Could Provide More Detailed

Information (GGD-98-51, Mar. 6, 1998).

Stock Market Automation: Exchanges Have Increased Systems’ Capacities

Since the 1987 Market Crash (GAO/IMTEC-91-37, May 10, 1991).

Financial Markets: Active Oversight of Market Automation by SEC and

CFTC Needed (GAO/IMTEC-91-21, Apr. 2, 1991).
Page 49 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Page 50 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
Page 51 GAO/GGD/AIMD-00-319 Decimal-Trading Delay
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