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

Letter

Background

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.

Professional Traders on Electronic Markets Are the Primary Users of Subpenny Quotations

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.

Market Participants Cited Advantages and Disadvantages to Subpenny Pricing

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.

SEC’s Proposal to Ban Subpenny Quoting Appears to Have Widespread Support

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.

GAO’s Review of the Impacts of Decimal Pricing Is Ongoing

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.

Observations

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.

GAO Contacts and Staff Acknowledgement

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.