Where It BeganSome brief history first. Until its recent switch to decimals, the U.S. markets stood alone in quoting stock prices in anything but decimals. Why the infatuation with fractions? You can trace its roots back to the Buttonwood Agreement in 1792 that helped create a formal U.S. market for stocks. In trying to set up domestic markets, brokers at the time looked for another market on which to base their own.
About TicksThe former objective has certainly been met. There can be little doubt that quoting a stock at 11 1/8 is more confusing to many investors than quoting it at $11.125. Not only that, the change makes it easier to imagine what it might cost to buy, say, 100 shares. And that increased clarity around pricing has been a good thing for the markets, whatever retrograde fans of fractions might say. The trouble, however, is that the push to decimalization was really about two things. There was the obvious -- replacing fractions with decimals, something only lovers of vacuum tubes and treadle sewing machines would quibble with. But the change also included a decrease in the minimum tick size. Far from being an entomological term, minimum tick size refers to the smallest price difference by which a stock price can change. Orthodox economics might appear to say that prices shouldn't be stipulated at all. No one tells corner stores that they can only price Pepsi in 12.5-cent increments, so why are stock quotes different? Understandably, perhaps, brokers, specialists firms and some large institutional investors will tell you that tick size is different. They have a point. Tick size provides a number of services to the market. First, it implicitly pays providers of liquidity. In other words, that 12.5-cent spread becomes, in a sense, my payment for standing ready to trade with all comers. It's good money (or at least it was) if you can get it. Because, so the argument goes, if you want liquidity and immediacy, you have to be willing to pay for it. Second, a minimum tick size helps keep people from jumping around orders.
Say there's a limit order to sell a particular stock at $10 and stocks are quoted in eighths. If a market order comes in that would have hit that limit order, a specialist can pick off the order by offering a higher price. When stocks are quoted in eighths the specialist would have to bid at least 10 1/8 -- a 1.25% premium.But things change if the minimum tick size falls to a penny, as it has in many cases under decimalization. In that case a specialist firm could jump around the limit order by bidding as little $10.01, a miniscule one-tenth of a percent more than that limit order sitting on the books. They could then, of course, turn around and hit the limit order, neatly profiting from the difference in the transaction. It's a legitimate concern. Not just because of the gaming problem, but because of the effect it would have on the order book. If you were a large institutional investor and you know that this sort of tomfoolery would be going on, you would be more likely to hide your real trading interest. You might avoid limit orders, you might route through electronic markets, you might break your orders up into smaller pieces. All of these actions make markets less open and transparent, and potentially increase the time and cost involved in closing trades.
Altering SpreadsSo, has it happened? Well, there is a tsunami of academic literature on the subject, so I won't bore you with it all. There are two main results. First, spreads have tightened anywhere from 20% to 50%, depending on the exchange, the stock price, the volume of trading and the perceived risk of the stock. That is, of course, generally good for investors, large and small. They pay less of a premium to trade. On the other hand, the overall depth of visible liquidity has decreased. The limit order book is generally thinner, and investors -- especially large ones -- are clearly hiding their orders. But complex trades are still being completed, and a recent study (Chakravarty, Panchapagesan and Wood (2002)) has shown the institutional costs have declined around $220 million a year overall, despite what some feared. Obviously there's considerably more liquidity in the market than is apparent through limit orders outside the best bid and offer. All of this brings us back to SEC Chairman Donaldson's musings this week about decimalization.
Some readers who emailed me after my original comments muttered darkly about Donaldson's conflict of interest. He was, they argued, the co-founder of Donaldson Lufkin & Jenrette; in proposing a rethink of decimalization, these readers contended, he was just offering a leg up to his former colleagues by returning them to happier days of larger spreads.
Minimum ConsiderationsThat seems like conspiratorial "black helicopter" talk to me. More realistically, Chairman Donaldson is being assailed with conflicting research and analysis about changes to the minimum tick size, and he took the rhetorical short cut of equating minimum tick size with decimalization. They're not the same thing, of course, and it's too bad he perpetuated the confusion. Nevertheless, having waded through many of the studies, I feel for the guy. The minimum tick size topic is wearying stuff, and it may yet turn out that there are defensible reasons to increase the minimum tick. Perhaps Donaldson and the SEC will find a flaw in the aforementioned study, or others like it. If so, there may be a small increase in the minimum tick size for stocks over some price, or depending on volume. Anything is possible. But whatever happens, it has nothing to do with decimalization. And that's here to stay.
We hope you've enjoyed today's special bonus from RealMoney, our premium sister site. To sign up for RealMoney, where you can read commentary like this in real time, please