Decimalizing liquidity?

SEC chief William Donaldson is rumbling about taking a closer look at “decimalization”. While most investors see prices being quoted in pennies rather than fractions as a huge win, the industry isn’t so sure, and it tells regular scare-stories about decreased spreads leading to lower liquidity.

Translating from broker-speak into real-person speak, brokers liked fractional price differences because they could buy stock from Joe at $10¼ and sell it to Jane at $10½, making 50 cents on the brain-dead transaction. But in a world of decimals where there was no pre-ordained reason for such large differences (“spreads”) between the two prices (the “bid” and the “ask”) market-making suddenly became much less profitable.

That is, of course, good for you and I. Or is it? The fear about lower liquidity is that smaller spreads will mean fewer brokers will be willing to play at any particular price, given how little money they’re likely to make from the transaction. And if that were to happen, then you and I would suffer, as it would become difficult to complete trades, especially large trades, and/or trades in stocks that didn’t trade much volume.

The hypothesis is easily tested, if you have the data. The most exacting decimalization study I have seen (Chakravarty, Panchapagesan, & Wood (NBER 2002)) shows there is little cause for alarm. Institutions, post-decimalization, saw an average 13 basis point cost improvement, or roughly $224-million per month in savings, with no impact on trade execution.

Stat arbs, daytraders, and some specialists may not like decimalization – and it has transformed the limit order book — but investors, both retail and institutional, have done just fine. The prior system was rigged to force a profit to traders through price restrictions; the current system lets the market find the price that keeps things profitable enough for traders to be willing to play.  Leave decimalization alone, Bill.

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