Fixing the Markets' Penny Problems


By Mike McNamee Never before has the world of high finance struggled so much over pennies. The New York Stock Exchange's recent switch to "penny trading" -- quoting and trading stock prices in one-cent increments, instead of sixteenths of a dollar -- has unleashed a flurry of complaints. Market players gripe they can't tell what the best prices for shares will be before they place their orders. Regulators fret that small investors are being scared away from placing limit orders, robbing the market of competition and better prices.

Penny problems could get even worse when Nasdaq converts to decimal trading in April. The Security Traders Assn. has warned the Securities & Exchange Commission that Nasdaq's computerized-messaging systems could break down under the expected surge in quotes and trades. Nasdaq insists it's ready. But to many on Wall Street, the "big bang" approach -- switching 4,800 stocks to cents on Apr. 9 -- is a recipe for more trouble.

SKIPPING NICKELS. The markets have no one to blame but themselves. As far back as 1997, when Congress started pressing for a switch to decimal pricing in stocks, academics and the SEC predicted in detail the pitfalls of penny trading. But the markets, after stalling for years, are now rushing their transition: Instead of moving from sixteenths to nickels and eventually to pennies, they skipped straight to pennies. Now they can't go back to nickels: "They'll be pummeled if they backtrack," warns an SEC official. So the exchanges are stuck.

The solutions aren't easy -- but they aren't rocket science, either. The markets need to do two things immediately: Improve their technology, and institute new rules to protect investors.

Decimal trading has advantages. It's easier to understand $17.44 than 17 7/16, and investors can get better prices if the "tick," or minimum price move, is 1 cent rather than a sixteenth (6.25 cents). But researchers have long known that increasing the number of prices at which dealers can trade will also multiply the number of quotes. Rather than bidding to buy, say, 500 shares at 15 1/4, a dealer will now post several bids, each for 100 shares, between $15.20 and $15.25. That puts more strain on the quote system.

MEASURED SWITCH? The solution to Nasdaq's capacity problem is fairly simple: Learn something from the New York Stock Exchange switch. The junior market should ease into penny trading over three months, rather than crashing into it over four weeks. True, any delay would raise a howl on Capitol Hill. But Congress will be just as mad if Nasdaq's trading breaks down. Then investors will be far worse off.

At the NYSE, penny trading is helping the pros at the expense of investors. Take, limit orders. These are orders to buy or sell shares at a targeted price. Former SEC Chairman Arthur Levitt Jr. encouraged limit orders to give small investors an easy way to outbid professional traders. But penny pricing gives the advantage back to the pros. Say your limit order at $20.06 is the best price offered for a stock. When stocks traded in fractions, a floor broker couldn't step in line ahead of you unless he offered $20.125. But now, the pro can offer just $20.07, and snatch up the shares you wanted.

Institutional investors -- pensions and mutual funds -- have a similar complaint. Two big funds, acting through their brokers, might arrange a trade for 10,000 shares at $25.17. The brokers then send this "clean cross" to the specialist -- a floor dealer charged with making sure the stock trades smoothly. This way, the block will show up on NYSE's tape. But the specialist or floor broker can break up that trade by offering to sell 500 shares at $25.16. The buying mutual fund saves $5, but the seller, which paid commissions to get a clean sale of 10,000 shares, is now stuck with 500 unwanted shares.

MAKE PROS PAY. Specialists insist they're not "pennying" such trades. "When you see trades go off at every penny, that's buyers and sellers interacting," says Michael LaBranche, CEO of NYSE specialists LaBranche & Co. But just to be sure, the Big Board should make floor pros pay. To step ahead of a posted limit order or to take a piece of a clean cross, a specialist or floor broker should be required to beat the quoted price by a nickel -- not just a penny.

Stronger technology and fairer rules will help investors adapt to penny trading. Long term, the best way to fit pennies into the stock market is for companies to split their shares until most stocks are trading for around $5. Georgetown University finance professor James Angel points out that NYSE stocks consistently clustered between $30 and $40 from the 1930s through 1997. That means the trading tick -- then an eighth -- was about 0.3% of the share price. With the tick down to 1 cent, share prices should come down proportionately. "All around the world, the optimal tick seems to be about 0.25% of the typical share price," Angel says.

That won't convince Warren Buffett, who swears he'll never split Berkshire Hathaway, whose "low-price" B shares cost $2,344. And it may take years for CFOs of other companies to get used to the idea that their shares should be trading at bulletin-board prices. In the meantime, Nasdaq and the NYSE need to act -- and fast. Penny problems are undermining investor confidence in their markets -- just when they need it the most. McNamee covers markets and investing for BusinessWeek from Washington. Christopher H. Schmitt in Washington also contributed to this story


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