Reprint permission from the July 14, 2003 issue of Crain's Chicago Business.
The new chairman of the Securities and Exchange Commission claims he's committed to restoring confidence in the stock markets, but William Donaldson's recent criticism of decimal pricing suggests he may be bowing to pressure from Wall Street insiders at the expense of ordinary investors.
Two years ago, the major U.S. stock exchanges and markets all agreed to quote stock prices in pennies, rather than in sixteenths of a dollar (6.25 cents). In transaction after transaction, the change has narrowed the spread — the difference between the price at which a brokerage firm buys a stock from one investor and the price at which the firm sells it to another.The bigger the spread, the happier Wall Street is. And penny pricing has eaten into the profits of market makers, hedge fund managers, traders and exchanges.
But retail investors have prospered. When spreads narrow, small investors can buy shares a little cheaper and keep a little more when they sell. In market jargon, decimals have improved the "inside quote," the highest bid to buy a stock and the lowest offer to sell one.
So, penny pricing means better deals for individual investors on their retail trades. It also means more profits for mutual funds, which suffer less slippage, the capital lost when investment managers can't execute their trades as tightly as they'd like.
One would expect Mr. Donaldson to be happy, but he isn't.
He argues that decimal pricing actually may have made trades more costly because it has reduced the number of shares available at the inside quote. Big trades of thousands of shares are now more likely to exceed the number of shares offered at the best bid or ask price.
He also claims that decimals encourage the abusive practice known as "penny jumping," where self-serving floor brokers or other middlemen buy or sell just ahead of fund managers by beating their prices by just a penny. Penny jumping makes markets less liquid and, consequently, shares more expensive.
The truth is that institutional investors are adjusting their trading styles to the decimalized world. Although transaction costs were higher when decimals were introduced, they have come down markedly.
And penny jumping can easily be stopped in its tracks, no matter how prices are quoted. All the Securities and Exchange Commission needs to do is adopt a simple rule: The execution of large, "limit order" trades — orders to buy or sell shares at predetermined prices — should be executed automatically, untouched by human hands.
If Mr. Donaldson were really fighting for the little guy, the mutual fund industry would line up behind him. But the Investment Company Institute, the trade association representing virtually every mutual fund in the nation, rejects Mr. Donaldson's flawed thesis and strongly supports decimalization. The institute's common-sense conclusions: Decimalization increases price competition, which is good for investors and the markets.
It's clear that industry players benefited from fractional trading because of the large price increments. Too bad that Mr. Donaldson, the self-proclaimed reformer who's out to convince investors that the markets aren't rigged, seems to be promoting the widening of spreads to boost Wall Street's profits.
Marc J. Lane ([email protected]) is a Chicago lawyer and financial planner and an adjunct professor of law at Northwestern University School of Law.
Copyright © 2003 by Crains Communications Inc.