Decimals Assignment Sends Brokerages Back to the Blackboard

Investors will probably notice some extra pocket change after stock prices convert to decimals from fractions. Brokerages, on the other hand, may find themselves coming up a few cents short.

And as anyone who keep a coin jar knows, pennies can add up.

The Securities and Exchange Commission on Friday told the stock and options markets to begin quoting prices in decimals on July 3. So during the year's last six months, the exchanges will begin pricing stocks in five-cent increments and will experiment with penny increments on a "sample" of securities. Currently, stock prices are quoted in fractions, usually in increments of 1/16 of a dollar, which equals roughly 6.25 cents.

The move will most likely narrow the difference between the price offered by buyers, known as the bid, and the price requested by sellers, called the ask. Market makers, which match buyers and sellers but often have to take one side of the trade to guarantee an orderly market, make money off the spread.

That means that firms like Knight/Trimark (NITE Quote) and Merrill Lynch (MER Quote) will have to turn elsewhere to boost their income because history suggests that as spreads narrow, brokerages' revenues suffer. So they'll either decrease the amount of risk they take by making markets in fewer stocks, or they'll try to trade more stock.

In addition, the SEC's firm start date means that brokerages (and the exchanges) will have to ramp up their technology spending to get everything set for decimalization.

"It may be a shock to the system," says Amy Butte, an analyst at Bear Stearns. "I think a lot of firms thought that decimalization was going to be pushed back So, as a result, a lot of them have put their concerns about it on the backburner."

Of course, brokerages have learned to cope with radical changes in the market many times before. In 1997, the exchanges introduced "teenies," or quotes in increments of 1/16 as compared to the previous 1/8. That effectively narrowed spreads. In combination with other order handling changes, trading firms' earnings declined.

And this time around the move only narrows the spread by 1.25 cents. However, the potential introduction of penny increments -- which would introduce a change almost as large as in 1997 -- looms.

It's that penny change that may pack a punch, but unfortunately, there's little data on how much. For example during a conference call on Jan. 19, Kenneth Pasternak, Knight's chief executive, said his firm hadn't worked out a scenario based on penny increments. A change to five-cent increments would have a minimal impact on earnings, he said, but would probably reduce revenue by about 5%. To make that up, he said, Knight would probably decrease the amount of rebates it pays to brokerages for sending orders its way.

To combat less profitable, narrower spreads, market makers may also cut back on some of the more risky, unprofitable trades, Pasternak said Friday in an interview.

"If [a market maker] can't create a business model that has economic viability, he's going to take his capital somewhere else," Pasternak said.

Scott Appleby, an analyst at Robertson Stephens, a unit of FleetBoston (FBF Quote), says he already had factored in the uncertain climate of decimalization, along with other market structure uncertainties, in making earnings estimates for Knight in 2001. I/B/E/S puts the consensus estimate at $2.19 per share for Knight in 2001. While Appleby doesn't know if the five-cent increment will matter, he says the real evidence will come in the third quarter.

One traditional Wall Street firm is hoping to make up the difference by trading more, not less.

"We are expecting that any loss in spread revenue would be made up in volume," says a member of Merrill Lynch's (MER Quote) executive circle, requesting anonymity. If investors can trade in increments of a penny, instead of fractions of a dollar, Merrill reasons that more people will trade, and trade more often.

Meanwhile, with more retail investors trading for themselves online, the shift to decimals also will mean changes to investing habits. For example, DLJdirect(DIR Quote) Chief Executive Blake Darcy said recently that one question decimalization raises concerns prices investors should use when entering limit orders. For example, now an investor might want to buy at 11 1/8. Under decimalization, that would be comparable to 11.125. But if stocks were trading in pennies, how would an investor decide whether to put in an order at 11.01 or 11.02? After all, the difference is only a penny.