FLASHBACK FRIDAY: Decimalization Cuts Dealer Profit
One-eighth. A sixteenth. Three quarters.
Remember when stocks were quoted and traded in fractions? “Five hundred shares trading up an eighth, what do you want to do?”
Just as the fallout from any Millennium Bug or residual Y2K concerns was exiting US financial firms’ collective radar, Wall Street was staring at a new paradigm in trading – moving from fractions to decimals. The move had revolutionary implications – from testing Wall Street’s technology to the ability of firms to make a living. Decimalization had the potential to change the trading landscape for both buy- and sell-side firms as well as retail mom and pop traders.
One retired buy-side trader who spoke with Traders Magazine remembers the time well.
“When we couldn’t quote in fractions or trade that way anymore, it really killed us,” the former buy-side trader said. “And it didn’t just kill us but the entire business. It took the markup/markdown business where you are making a 1/16 or an 1/8 down to pennies. Commissions eroded into single pennies.”
It became a marketplace where only the strong could survive. Brokers closed. Firms shrunk in size. And while the largest firms managed to survive and rely on either non-equity trading revenue streams or other businesses such as investment banking.
Another former trader added that he remembers cash commissions for full-service broking as being in the 5 to 6 cents range and the 2 cent range for what then was considered electronic trading. In comparison, now full-service service costs 2 to 3 cents and electronic trade execution is around 1 cent or less.
“Dealers are still making money as they are still in business,” he said. “But some firms definitely went under. We had commission rates going down and trading volumes going up. The smaller firms got wiped out. Just look at the modern trading floor and check out the names and posts – see who is left.”
Now, he added, as commission rates are still down and volume has slowed too. How are the brokers paying their bills, he asked? “You know that decimals have been really hard on them.”
Another byproduct of decimals was the erosion of the block trade, a third trader commented. Gone are publicly quoted blocks of multiple-hundred shares that broker could charge extra for executing. The old adage, “You want size…you have to reach” went the way of the Edsel.
“It took the whole concept of getting liquidity at a price away,” he said. “Instead of having huge blocks at every 1/8 on an exchange, you now have everything in pennies and hidden off board or in dark pools. There is no more price discovery out in the open.”
And that sounded the death knell for the exchange open trading floor to many. As Traders Magazine observed firsthand on a visit to an exchange, gone is the noise of floor traders jostling for shares and picking up phones. No more order tickets littering the floor. At one point, the hum of the air conditioning system could be heard.
So what has decimalization brought?
“It’s cheaper than hell to get a trade done,” said one veteran trader. “Mom and pop can get a penny spread but institutions have to go through hoops for pennies. It hasn’t helped the industry in terms of profitability.”
This article originally appeared in the September 2000 edition of Traders Magazine
Study: Decimals Cut Into Dealers’ Profits
By William Hoffman
Decimalization is cutting into dealers’ profit margins, according to a study by two finance professors.
The study concludes that quoted bid-ask spreads have declined “dramatically” in all 13 stocks taking part in the pilot decimalization program. On the American Stock Exchange, a decline of about 47 percent was noted for the six stocks in the program, while spreads shrunk by about 15 percent for the seven New York Stock Exchange Stocks taking part.
Dr. Robert Wood of the University of Memphis, who co-wrote the study with Dr. Sugato Chakravarty of Purdue University, said it was too early to draw conclusions.
Decimal-priced trading in a limited number of stocks started on Aug. 28. Nasdaq is expected to start pricing in decimals in March. All U.S. stocks, moreover, are slated to trade in decimals the following month.
The study, which took data from just before and immediately after the introduction of decimals, found that effective bid-ask spreads also fell, on average, by about 47 percent at the Amex and by 38 percent at the Big Board.
The effective bid-ask spread was defined by the professors as “twice the absolute difference between the transaction price and the midpoint of the prevailing quoted bid/ask spread.”
Among traders, the impact of decimilization was generally uneventful. The manager of equity trading at one large mutual fund observed that decimal prices on U.S. stocks seem to be congregating near their equivalent fractional values.
Thus, a stock trading at 16 and one-half under the old order posts around $16.50 in the new scheme. The mutual fund trading manager said he observed the same transitory phenomena when stock prices converted from eighths to sixteenths. (The trader was contacted by telephone in the early phase of the pilot, noting that his desk had not yet traded decimal-priced stocks.)
A few glitches have been rumored. James H. Lee, president of Momentum Securities, in New York, said associates told him that some third-party vendors who redistribute quotes are experiencing technical problems reliably and quickly converting prices from fractions to decimals.
The trading manager at the mutual fund said the investing public probably is likely not in tune with decimals.
“I don’t think the investing public in general knows that Gateway now trades in decimals,” he said.
Yet with heavyweights America Online, Goodyear Tire, and Time-Warner joining the march to penny pricing day traders were expected to take advantage of brokers’ slimmer profit margins. That may speed public acceptance of decimalization, a trader said.
“After that, we should have a much better feel for how our systems will handle the continuing decimalization of stocks,” he said.
Meanwhile, Congress and the Securities and Exchange Commission are monitoring decimalization. “Our responsibility is to regulate the markets,” said SEC spokesman John Heine, “so we’re involved in watching them, too.”
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