Securities Markets: Preliminary Observations on the Use of Subpenny Pricing
Published: 2004-07-22T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2001, U.S. stock and options markets, which had previously quoted prices in fractions, began quoting in decimals. Since then, various positive and negative effects have been attributed to the transition to decimal pricing. As part of this transition, the major stock markets chose one penny ($.01) as the minimum price variation for quoting prices for orders to buy or sell. However, some electronic trading systems allowed their customers to quote in increments of less than a penny (such as $.001). The use of subpenny prices for securities trades has proved controversial and the Securities and Exchange Commission (SEC) has proposed a ban against subpenny quoting for stocks priced above one dollar across all U.S. markets. As part of ongoing work that examines a range of issues relating to decimal pricing, GAO reviewed (1) how widely subpenny prices are used and by whom, (2) the advantages and disadvantages of subpenny pricing cited by market participants, and (3) market participants' reactions to SEC's proposed ban.
section_title: What GAO Found
paragraphs: Data on the extent to which market participants are quoting in subpenny increments across all U.S. equity markets are not routinely reported or readily available. However, studies of limited scope conducted by regulators and one market found that subpenny prices were not widely used. For example, a study done by the Nasdaq Stock Market in 2001 of Nasdaq stocks found that subpenny increments were used in less than 15 percent of the orders that specified a price (limit orders). Currently, the major markets do not allow subpenny quoting but a few electronic trading systems that match customer orders do. On electronic trading systems, professional traders (such as those employed by hedge funds) use subpenny quotes to gain a competitive price advantage over other orders. However, many market participants GAO interviewed cited numerous disadvantages to the use of subpenny quoting. They argued that subpenny quotes primarily benefit the professional traders who subscribe to market data systems displaying subpenny prices and who use fast systems to transmit their orders to take advantage of such prices. As a result, most investors do not benefit from subpenny quotes because they do not use these systems and because many broker-dealers do not accept orders from their customers in subpenny increments. In addition, participants said that subpenny quotes allow some traders to step ahead of others' orders for an economically insignificant amount. They said this discourages other traders from submitting limit orders and reduces overall transparency and liquidity in the markets. Based on the work GAO has conducted to date, including a limited review of comments on SEC's proposal to ban subpenny quoting, most market participants support SEC's proposed action. However, some organizations opposed to the ban said that it could reduce the ability of traders to offer better prices and stifle technological innovation and reduce market participants' incentive to invest in better systems. Although some electronic trading systems supported the ban, others indicated that the decision to use subpenny quotes should be left to market participants who, as technology advances, may increasingly find subpenny quotes more useful than they do today. In addition to reviewing subpenny pricing, GAO continues to review the broader impacts of decimal pricing on markets, securities firms, and investors. As part of this work, we plan to conduct original analysis using a comprehensive database of trades and quotes from U.S. markets to identify trends in quoted spreads, clustering of quotes and trades across certain prices, and other potential changes since decimal pricing was introduced.

section_title: Letter
paragraphs: It is a pleasure to be here today to participate in this important hearing on  market structure issues. As you requested, my statement today will focus  on the use of subpenny quotes in the securities markets. I also will  describe the work we are conducting for this Committee’s Subcommittee  on Securities and Investment as part of our ongoing broader study of the  impact of decimal pricing on the securities markets, firms, and investors.
Many changes have occurred since the U.S. markets transitioned from  pricing stocks and options in fractions of a dollar to using decimal prices.  Many participants cite decimal pricing as providing benefits to small  investors, but others argue that it has contributed to lower liquidity and  reduced the willingness and ability of securities firms to execute their  customers’ orders. As part of the transition to decimal prices, the major  stock markets chose one penny as the minimum price variation (MPV),  which is the minimum increment in which the prices of stocks on these  markets are allowed to be quoted. However, some electronic trading  systems allow their customers to quote in increments of less than a penny.  The use of subpenny prices for stock trades has proven controversial, and  the Securities and Exchange Commission (SEC) has proposed a ban  against subpenny quoting for stocks priced above one dollar across all U.S.  markets.
Today, I will discuss the preliminary results of our review of subpenny  pricing issues, including:    how widely subpenny pricing is used and who uses it,  the advantages and disadvantages of subpenny pricing, as reported by  market participants, and the reactions of market participants to SEC’s proposed ban on subpenny  quoting.
To address these issues, we interviewed a variety of market participants,  including regulators, markets, electronic trading systems, broker-dealers,  industry associations, trade analysis firms, and institutional investors. We  also reviewed relevant studies, testimonies, and comment letters on SEC’s  regulatory proposal. Our work is ongoing, and we expect to report on the  broader range of decimal pricing issues later this year.
Although data on the extent to which market participants are quoting in  subpenny increments are not routinely reported or readily available, the  use of subpenny quotes in U.S. equity markets appears to be limited.  Currently, the major markets do not allow subpenny quoting but a few  electronic trading systems that match customer orders do. Professional  traders using those electronic trading systems have used subpenny quotes  to gain a competitive price advantage over other orders. The general  investing public does not use such systems and can usually see prices only  in penny increments.
Although some market participants saw benefits to subpenny pricing, most  cited various disadvantages to the use of subpenny quotes. The advantages  market participants cited included gaining order priority, price  improvement, and more competitive and efficient markets. However, other  market participants cited disadvantages.  For example, subpenny quotes  primarily benefit professional traders who subscribe to market data  systems displaying subpenny prices and who use fast order routing  systems to access prices.  These prices are usually not available to the  general investing public. In addition, market participants noted subpenny  quotes allow some traders to step ahead of others’ orders for an  economically insignificant amount.  Finally, they argued that this stepping  ahead discourages other traders from submitting limit orders, which  reduces overall transparency and liquidity in the markets.
Based on the work we have conducted to date and a limited review of  some of the comments on SEC’s proposal to ban subpenny quoting, most  market participants appear to support SEC’s proposed action.  However,  some organizations opposed to the ban said that it could reduce the ability  of traders to offer better prices and stifle technological innovation and  reduce market participants’ incentive to invest in better systems.   Although some electronic trading systems supported the ban, other  electronic trading systems indicated that the decision to use subpenny  quotes should be left to market participants who, as technology advances,  may increasingly find subpenny quotes more useful than they do today. We  are also continuing to review the broader impacts of decimal pricing on  markets, securities firms, and investors. As part of this work, we also plan  to conduct original analysis using a database of trades and quotes  occurring on U.S. markets to identify trends in quoted spreads, clustering  of quotes and trades across certain prices, and other potential changes  since decimal pricing was introduced.
subsections: section_title: Background
paragraphs: In 2000, in response to calls from Congress, SEC directed U.S. stock and  options markets to change from quoting equity securities and options in  fractions of a dollar, such as 1/16th, to quoting in decimals. Proponents of  this change believed decimal pricing would make stock prices easier for  investors to understand, align U.S. markets with other major stock  markets of the world, and lower investors’ trading costs by narrowing  spreads to as little as one penny. At the time of SEC’s order, U.S. markets  were the only major securities markets in the world still trading in  fractions. After a phase-in period of several months, the major exchanges  and Nasdaq began using decimal pricing for all quotes on equity securities  and options on April 9, 2001. The national securities markets, including the  New York Stock Exchange (NYSE) and Nasdaq, chose to allow quoting on  their markets with an MPV, or tick size, of one penny.  The MPV is the  minimum increment in which stock prices on these markets are allowed to  be quoted. However, even before the transition to decimal pricing, some  stocks were trading in increments of less than the MPV, such as 1/256th of a  dollar.
section_title: Professional Traders on Electronic Markets Are the Primary Users of Subpenny Quotations
paragraphs: Since U.S. markets converted to decimal pricing, professional traders  trading outside the national securities markets have been the primary  users of subpenny prices. Although the national securities markets set  their MPVs at one penny, several electronic trading systemsknown as  electronic communication networks (ECNs)display quotes and execute  orders entered by their customers in subpennies and allow traders to  quote prices and trade in subpenny increments. When quotes from these  proprietary systems are displayed to traders outside the proprietary  systems, the quotes are rounded to the nearest full penny increment— specifically, down for buy orders and up for sell orders—to comply with  the required one-penny MPV of the national securities markets. In such  instances, orders executed against these quotes receive the subpenny  price. According to SEC staff and others, although several ECNs initially  allowed quoting in subpennies, some have curtailed the use of such  quotes. At the time we prepared this statement, we were aware of only two  ECNs that allowed quoting in subpennies—Instinet’s INET and Brut  ECN—for a few selected stocks.
The extent to which stocks are quoted in subpenny increments appears to  be limited. According to SEC staff, data on the extent to which subpenny  increments are used to quote securities across all U.S. equity markets are  not routinely reported or readily available. However, a 2001 Nasdaq report  to SEC that reviewed trading in stocks listed on its market showed that  less than 15 percent of limit orders were submitted in subpennies after  decimals were introduced. A vast majority of the subpenny limit orders  cited in the 2001 Nasdaq report were handled by a single ECN. SEC staff  also conducted a study of the use of subpennies in trading that took place  between April 21 and 25, 2003, and found that subpenny trades accounted  for about 13 percent of trades in Nasdaq stocks, 10 percent of trades in  American Stock Exchange stocks, and 1 percent of the trades in NYSE  stocks. These trade execution data, however, do not directly demonstrate  the extent of subpenny quoting, because trades may be executed using the  subpenny increment for other reasons. For example, some institutional  investors may ask their broker-dealers to execute orders at the weighted  average price at which a stock traded on a particular day. This weighted  average price can be carried out to several decimal places.
Representatives of one ECN told us that it allowed traders to quote certain  stocks in subpennies because its customers wanted to be able to quote in  these increments. They also said that this use of subpenny quotes was a  way to differentiate their business from that of their competitors. In  addition, these ECN representatives said that subpenny quoting enhanced  the efficiency of trading in certain actively traded securities, such as the  Nasdaq 100 Index Tracking Stock (QQQ). According to SEC staff and  market participants with whom we spoke, subpenny quotes are used  primarily by professional traders, such as day traders or traders for hedge  funds, to gain a competitive price advantage over other traders. However,  some ECNs that were allowing their customers to use subpenny quoting  more widely have significantly curtailed the number of stocks that could  be quoted in subpennies. According to a representative at one ECN, its  share of the total trading volumes of these stocks increased rather than  declined after it stopped quoting in subpennies.
section_title: Market Participants Cited Advantages and Disadvantages to Subpenny Pricing
paragraphs: Although some market participants saw benefits to subpenny pricing, most  cited various disadvantages to the use of subpenny quotes. Some market  participants said subpenny quoting allowed traders to raise the priority of  their orders. For example, a representative of one ECN told us that when a  large number of traders were all quoting the same full penny price, one  trader could increase the chances of executing a trade by improving the  price by a subpenny increment. This representative also said that the  customers on the other side of the trade also benefited from the subpenny  increment, as their orders were executed at slightly better prices. ECNs  we contacted also told us that subpenny pricing allowed for more efficient  and competitive markets. For example, a one-cent MPV could act as an  artificial constraint on pricing for stocks that trade actively. According to  representatives of one ECN, allowing such actively traded stocks to trade  in increments of less than a penny allows buyers and sellers to discover a  stock’s true market price.
However, most of the market participants we contacted mainly cited  disadvantages to subpenny quoting. First, many participants told us that  the benefits of subpenny pricing accrue to professional traders but not to  the general investing public. Representatives of one firm with whom we  spoke told us that quotes in subpenny increments were available to  professional traders who pay to access proprietary trading systems the  ECNs operate. Through these proprietary systems, professional traders  can use fast order routing systems to obtain the subpenny prices, which  may be better than those that are publicly displayed on other markets that  use one-cent MPVs. According to market participants, many broker- dealers do not accept orders from their customers in subpenny  increments, and so the average investor generally cannot access the  subpenny quotes. A representative of a large broker-dealer stated at an  April 2004 SEC hearing that his firm had stopped allowing clients to  submit orders priced in subpenny increments for this reason. Further,  representatives at one securities market argued that the integrity of the  securities markets was reduced when some traders have advantages over  others.
Many of the market participants we contacted told us that quoting in  subpenny increments also resulted in more instances of traders “stepping  ahead” of large limit orders. According to some market participants,  reduced MPVs that accompanied decimal pricing have negatively affected  traders displaying large orders at one price.  These traders find that their  orders go unexecuted or have to be resubmitted when other traders step  ahead of them by quoting a better price in increasingly small amounts.  These participants argued that at higher MPVs, which were previously 1/8th  or 1/16th of a dollar per share, traders stepping ahead of other orders were  taking a greater financial risk if their orders were executed and prices then  moved against them. However, market participants with whom we spoke  said subpenny increments were generally an economically insignificant  amount and that traders using them faced much lower financial risk.  Recent SEC and Nasdaq studies of subpenny trading found that most  trades executed in subpenny increments clustered at prices 1/10th of a cent  above and below the next full penny increment, suggesting that subpenny  quotes were primarily being used to gain priority over other orders and  were not otherwise the result of natural trading activities. Market  participants also told us that the more likely it is that a trader can step  ahead of other orders—as they can by using subpenny quotes—the less  likely traders are to enter their limit orders, which are an important source  of liquidity.  This reduced incentive to enter limit orders also reduces the  number of shares displayed for sale and potentially affects liquidity and  market efficiency.
Furthermore, some market participants also saw subpenny quoting as  reducing market transparency for retail investors and depth for  institutional investors. When the MPV decreases, for example to  subpennies, the number of potential prices at which shares can be  quoted—called price points—increases, because displayed liquidity is  spread over more price points. For example, subpenny quotes using 1/10th  of a penny ($.001) increase the number of price points to 1,000 per dollar.  This affects retail investors, because fewer shares are generally quoted at  the only prices visible to them—the current best prices for purchase or  sale. This affects institutional investors, because the more price points that  must be considered, the more difficult it becomes to determine whether  sufficient shares are available to fill larger orders. Market participants said  that quotes in a subpenny pricing environment change more rapidly (a  phenomenon known as quote flickering) and make determining the actual  prices at which shares are available more difficult. Quote flickering  reduces broker-dealers’ ability to determine whether the trades they have  conducted satisfy their regulatory responsibility to obtain the best  execution price for their clients. Finally, some market participants told us  that subpenny pricing has the potential to greatly increase the processing  and transmission capacity requirements for the market data systems that  transmit price and trade information, causing firms to expend resources to  redesign electronic systems.
section_title: SEC’s Proposal to Ban Subpenny Quoting Appears to Have Widespread Support
paragraphs: SEC’s proposed rule to prohibit market participants from pricing stocks in  increments of less than one penny appears to be widely supported. As part  of its proposed rule changes to Regulation NMS, SEC has proposed  establishing a uniform pricing standard for stocks that trade in all market  centers, which SEC defines as exchanges, over-the-counter market  makers, specialists, and ECNs. Specifically, SEC proposes to prohibit  market participants from accepting, ranking, or displaying orders, quotes,  or indications of interest in a pricing increment finer than a penny in any  stock, unless the stock has a share price of less than one dollar. The  proposed rule would not prohibit executing trades in increments of less  than one penny, which most markets currently permit, because there are  instances when subpenny trading is appropriate—for example, when the  trade’s price is based on some averaging mechanism. According to SEC  staff, this change would address differences in pricing that exist across  markets and that benefit some investors at the expense of the general  investing public. According to the staff, banning subpenny pricing should  also reduce the extent to which limit orders lose priority because of  subpenny pricing, thereby preserving incentives to display limit orders,  which are an important source of liquidity for the markets.
Most market participants we have contacted to date and most commenting  on SEC’s proposal appear to support a ban on subpenny pricing for stocks  priced at more than one dollar. Of the over 500 comment letters available  on SEC’s Web site as of July 16, 2004, we determined that about 50  provided comments on the proposed ban. Of these, 86 percent of the  commenters supported banning subpenny quoting. According to NYSE and  Nasdaq representatives with whom we spoke, the current existence of  quotes that not all investors can access is a significant reason for their  support of SEC’s proposed subpenny prohibition. Nasdaq’s support for  banning subpenny quoting comes despite filing for a proposed rule change  with SEC in 2003 that would permit Nasdaq to adopt an MPV of 1/10th of  one cent for its listed securities. According to the Nasdaq representatives,  if SEC does not prohibit subpenny quoting, Nasdaq would want SEC  approval to begin quoting in subpennies in order to compete with ECNs.   Nasdaq subsequently withdrew its propsed rule change, presumably  because SEC is proposing to ban subpennies in its proposed changes to  Regulation NMS. Representatives at several institutional investors and  broker-dealer firms also agreed that quoting in subpenny increments  should be prohibited. In its June 30, 2004, comment letter to SEC, the  Investment Company Institute (which represents the interests of the $7  trillion mutual fund industry) stated that quoting in subpennies eliminates  many of the benefits brought by decimal pricing and exacerbates many of  the unintended consequences that have arisen in the securities markets  since its implementation that have proven harmful to mutual funds and  their shareholders.
However, other market participants and other commenters opposed SEC’s  proposal to ban subpenny quoting.  Several of the organizations that  opposed a ban said that subpenny quotes allow traders more ability to  improve the prices they offer to others.  A group of 10 academic  researchers that commented to SEC argued that the impacts of subpenny  quoting on market transparency could be resolved with technology.  For  example, data vendors can choose to update quotes only when there are  meaningful changes.  A letter from a university regulatory research center  noted that banning subpenny quoting could stifle innovation in the way  that quotes are displayed to investors. For example, graphical displays  could replace flickering quotes with fluid motion and use patterns and  shapes to help investors recognize changes.  A ban could also reduce  incentives for other market participants to invest in innovative  technologies.
Opinions among some ECNs were mixed, with roughly an equal number  supporting and opposing SEC’s proposal to ban subpenny quoting.
Representatives of two ECNs indicated that SEC should not enact a ban,  arguing that tick size is best determined by demand in the marketplace.  Furthermore, representatives of two ECNs noted that stocks that trade at  a spread of a penny benefit from the increased efficiency afforded by  subpenny increments; one representative noted that a penny MPV  artificially constrains price discovery for these stocks. In addition, this  representative said that stocks with low share prices should be quoted in  subpenny increments because subpennies become economically  significant when the share price is a few dollars or less. Finally, these  representatives said that as more traders and firms upgrade their trading  technology, they may find more advantages from quoting in subpennies  and that a regulatory ban enacted now might become an unpopular  constraint in the future. One of the ECNs is supporting SEC’s proposal to  ban subpenny quoting because its customers preferred not to have  subpennies used on that ECN’s system.  At the time we prepared this  statement, we had not yet talked to entities that are reported to be key  users of subpenny quotes and who may be opposed to SEC’s proposal,  such as day traders, hedge funds, or entities whose sole business is  computer-enabled trading.
section_title: GAO’s Review of the Impacts of Decimal Pricing Is Ongoing
paragraphs: At the request of this Committee’s Subcommittee on Securities and  Investment, we are conducting additional work to review the impact of  decimal pricing on the securities markets, securities firms, and retail and  institutional investors. To conduct this work, we are reviewing relevant  regulatory, academic, and industry studies that address decimal pricing  impacts. We are also interviewing and obtaining information from market  participants, including:  securities markets, including stock and options markets; securities firms, including broker-dealers that conduct large-block trading,  market makers, and exchange specialists; industry associations, including those representing securities traders,  broker-dealers, and mutual funds;  trade analysis firms; institutional investors, including pension and mutual fund investment  managers; and academic researchers who have studied trading and decimal pricing.
To identify trends and changes since decimal pricing was introduced, we  are also attempting to collect and analyze data on the characteristics of  markets, firms, and investors and the impact of decimalization on these  entities (table 1).
In addition, we plan to conduct research and analysis using a  comprehensive electronic database of quotes and trades that have  occurred on U.S. stock markets. The Trade and Quote (TAQ) database  offered by NYSE consolidates all quotes and trades that have occurred on  NYSE, Nasdaq, the American Stock Exchange, and the regional exchanges.  As part of this research, we plan to expand and extend analysis done for a  recently published study on the impact of decimal pricing on trade  execution costs and market quality, including volatility and liquidity.
Among the types of information we plan to analyze using this database are:  quotation sizes (i.e., number of shares being quoted), the percentage of trades and shares executed at prices less or greater than  the best quoted price prevailing at the time of executions, and the volatility of returns from investing.
We plan to use this analysis to shed light on how trade execution costs and  market quality may have changed in transitioning from a fractional to a  decimal pricing environment. In addition to the variables considered in the  published study, we plan to gather data on trade size and the numbers of  trades and quotes that may provide evidence on changes in trading  behavior. We also plan to analyze the TAQ data to identify whether and to  what extent clustering occurs when quotes or trade executions occur  more frequently than would be expected at particular price points (e.g.,  multiples of 5 cents and 10 cents) despite the existence of the one-cent  tick.
section_title: Observations
paragraphs: Because we are continuing to review issues relating to decimal pricing, we  do not have definitive conclusions on subpenny pricing at this time. Our  work to date has shown that subpenny quoting can provide advantages to  some traders but can also create disadvantages to others and potentially  impair incentives to display liquidity. A significant majority of market  participants appear to support SEC’s proposed ban on quoting in  subpennies, but little information is available on the impact of using these  quotes. On the one hand, given that such quotes are currently used only in  a few trading venues and for a limited range of stocks, SEC’s proposed ban  would probably not result in a significant change for the overall markets  or most investors. On the other hand, if SEC did not ban subpenny quotes,  it is possible that exchanges and more markets would want to quote in  subpennies—a change that could have a significant impact on U.S. equity  markets. Still, a ban would take away the ability of individual markets and  investors to choose whether to use subpenny quotes if they decide their  use would be advantageous.  Subsequent changes in market structure,  technology, and investor needs could require SEC to reconsider whether  the use of subpenny quotes would be appropriate at some future date.
Mr. Chairman, this concludes my prepared statement. I would be happy to  respond to any questions that you or Members of the Committee may  have.
section_title: GAO Contacts and Staff Acknowledgement
paragraphs: For questions concerning this testimony, please contact Cody Goebel at  (202) 512-8678 or goebelc@gao.gov. Other key contributors to this  statement were Jordan Corey, Emily Chalmers, Joe Hunter, Kathryn  Supinski, and Richard Vagnoni.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.