Thursday, November 8, 2012

Back to the Future: Stock Prices Quoted with Fractions

By Tim Dulaney, PhD and Tim Husson, PhD

The Wall Street Journal recently reported that the SEC is considering reverting back to an old system in which stock prices were quoted using fractions.  Using fractions for stock prices in the US has its roots in a Spanish colonial currency whose smallest denomination was 1/8 of a doubloon, hence prices were quoted in eights. The NYSE, founded in 1792 within the Buttonwood agreement, modeled their listing system off the Spanish system (for more on this interesting story see here).

The largest number used for the denominator in the fraction, which determines the tick size, has varied over time and between exchanges.  This number also determines the smallest possible spread that can be quoted between those willing to buy and those willing to sell.  To illustrate this, suppose prices are only quoted in eighths ($0.125 increments).  That would imply that the smallest possible spread -- the difference between the price people are willing to sell a security and the price people are willing to pay for it -- would be $0.125, much larger than one cent.

Following an amendment (PDF) to the Securities Exchange Act of 1934 passed by Congress in 1997, the SEC implemented a controlled phase-in process requiring exchanges to list prices of equity securities and options on those securities based on dollars and cents.  Some argue that this decimalization has decreased spreads and, as a result, lowered transaction costs.  In fact, one SEC official was quoted in the WSJ article saying the decimalization switch "transferred billions of dollars from the pockets of brokers into the pockets of investors."

But the arguments presented in favor of the switch back to fractional stock prices seem disingenuous at best.  One executive at an investment bank essentially claims that if the bankers are able to collect more money on transaction fees (through higher spreads), then they could conduct more research and somehow spark growth in the financial sector.  That his company's bottom line would benefit from such an inflow of transaction fees is a more likely reason for his enthusiasm.

In fact, some have proposed the opposite change:  to allow stock quotes to take sub-penny quotes.  The idea here is that if the spread could be very small, high frequency trading would become less profitable and therefore less likely to affect stock prices or cause 'flash crashes' in markets.

Our take on this is that unless the change to fractions results in spreads that are subpenny (e.g. 1/200 increments of a dollar), it is unlikely that such a policy revision is in the best interest of investors.  We think market makers should be in the business of reducing transaction costs, not racing each other for rounding errors, and that larger spreads only lead to more rent-seeking from market makers.  It will be interesting to see if the SEC acts on this idea and what reasons the SEC cites for their action or inaction.

1 comment:

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