WASHINGTON - The switch to decimals by two of the nation's largest stock exchanges has given some institutional investors a big headache. Others are optimistic the change will result in narrower spreads and lower trading costs.
Late last month, the New York Stock Exchange switched to trading all 3,525 stocks in decimals, and the smaller American Stock Exchange also discarded fractions. The Nasdaq will complete the move from fractions in early April.
Because stocks can now trade a penny apart, instead of at intervals of 6.25 cents,some financial experts and large investors warn that trades will be more spread out instead of being clustered at a few price intervals, leading to a dramatic reduction in the size of trades, and to lower liquidity. Institutional investors now will have to dribble out their typically large trade orders instead of buying and selling big blocks of stock, they said.
Already, said Mary Leanza, who heads the in-house trading desk at the $40 billion Virginia Retirement System in Richmond, it has become more difficult to execute orders of 5,000 shares to 50,000 shares.
Instead of placing watertight limit orders with brokers, she said, institutional investors will have to give brokers working exchange floors greater flexibility. For example, instead of placing an order to buy 25,000 shares of a particular company at a price no higher than $36, the investor might need to give brokers the discretion to buy the stock at a penny or two higher.
Software already permits investors to place "smart" limit orders that adjust prices automatically depending on changing trading patterns, said Robert Wood, a finance professor at the University of Memphis in Tennessee.
"If we have large blocks to trade, we would rather be able to trade at one price. Now it's unlikely to happen," said Greg Rogers, partner and head trader at Aronson + Partners, Philadelphia, with $4.4 billion under management.
And, because the shift to decimals makes it that much easier for traders to cut ahead of large orders by paying either a penny extra or accepting a penny less, some experts warn big investors will be much more reluctant to place limit orders that stipulate a set price at which to buy or sell shares. And because limit orders increase liquidity, the shift will mean less liquidity.
In short, expect increased volatility and higher trading costs, they warn.
Transaction cost issue
"What was promised was lower transaction costs, but many people knew otherwise," said Larry Harris, a professor of finance at the Marshall School of Business at the University of Southern California in Los Angeles.
Daniel Weaver, another academic who has studied the issue, shares his gloomy view.
"People will stop putting in limit orders. Would you stand in line if someone can cut in front of you?" asked Mr. Weaver, a professor of finance at the Zicklin School of Business at New York's Baruch College.
Rather than revealing the price at which they want to buy or sell shares through limit orders, institutional investors will send in orders at the last minute when a stock trades at a price they want. That means large investors might have to pay brokers higher commissions. "If it takes longer to work a trade, they are going to charge more," Mr. Weaver said.
But proponents say the switch will result in lower spreads between the bid and the asked price, more trading volume over time, and better executions, so that investors will come out ahead.
The switch to decimals could lower trading costs by a penny or two a share, with shares eventually trading in 5-cent increments, said Carl Guidi, portfolio manager and head trader at the $170 billion California Public Employees' Retirement System, Sacramento. He isn't bothered by having to break up a transaction into small pieces, a shift that he said already has occurred, driven by changes on the Nasdaq stock market in the last few years.
John J. Wheeler, head of equity trading at the American Century Investments, a mutual fund group in Kansas City, Mo., which has $105 billion in assets, also is "cautiously optimistic" the change will drive trading costs down.
But Mr. Wheeler said decimals alone won't help lower trading costs unless the Big Board pitches in to help investors. The exchange will need to protect limit orders from traders wanting to cut ahead, he pointed out. It also would be helpful if the exchange opens the specialists' limit order book, increasing depth on the bid and asked side by showing investors more than just the highest bid or the lowest offer.
Opening the books
Richard A. Grasso, chairman and chief executive officer of the NYSE, said the exchange hopes to have a system in place by midyear that will require specialists to open their limit order books.