Decimalization: ECNs Grab Additional Market Share and Depth of Liquidity

The immense political and financial clout that the established securities exchanges and markets have in this country for preserving the status quo is nearly unparalleled. Indeed, though the Congress directed the SEC to create a national market system roughly 25 years ago, we have only recently seen the U.S. equity markets shift from fractions to decimal-based trading.

Despite mixed feelings expressed by exchange officials, specialists and market makers, in the late 1990s, the time had come for the traditional exchanges to adopt the pricing structure of the U.S. economy and the developed world's financial markets. To that end, in 1997, the SEC directed all U.S. stock exchanges and markets to convert to trading in decimal increments by September 2000.

Preliminary analysis of post-decimalization trading activity as reported by the NYSE and Nasdaq has yielded both expected and unexpected results. The goal of decimalization was to simplify and improve pricing for retail investors while making the U.S. markets more competitive on a global scale. In addition, decimalization was also expected to reduce trading costs for all investors by narrowing the trading spreads. To this end, decimalization is not all that it was cracked up to be. Though clearly benefiting retail traders who place orders on electronic communications networks (ECNs), the retail and institutional investor trading on the Nasdaq or NYSE have experienced decidedly mixed results.

There is little disputing the fact that it is now much easier for investors to recognize and more easily compare prices across competing markets. However, overall market transparency for issues trading on the traditional exchanges and Nasdaq have significantly degraded. In essence, the value of issue specific inside market or depth of interest information available from these venues has appreciably decreased with decimalization. The size of the inside market at any one time is now much smaller and less representative of the true underlying supply and demand. Having depth of liquidity information is vital for many investors as this data is often effectively used to determine timing and price of buys and sells.

As predicted, initial analysis of post-decimalization trading data shows that issues trading on the NYSE are experiencing a narrowing of effective spreads by 15 percent while the Nasdaq has observed a narrowing of roughly 50 percent. The effective spread for a security is the absolute value of twice the difference between the last trade price and mid-point between the inside bid and offer. On the surface, the conversion to decimalization went smoothly and with the desired beneficial effects on pricing and retail investor savings as defined by the SEC. What isn't so apparent is the negative effect decimalization has had on the quality and value of the NYSE's and Nasdaq's public quotation.

Traditional Markets Compete
With regard to market share and volume, ECNs from Instinet to MarketXT have seen increases resulting from decimalization. That was not expected. Though it is difficult and possibly a bit premature to gauge exactly how much additional activity can be attributed to decimalization alone, it seems clear that the recent change has some participants changing execution venues. In Instinet's case, the additional decimalization related volume can be attributed to institutional activity. The pricing switch has made it more difficult and generally more expensive for institutions to trade. Market makers, for instance, are finding it necessary to break up large orders to get them done. Many of these order fragments are being sent to ECNs for execution. Chalk another one up for the ECNs.

Due to the inherently open market data structure of the ECN limit order book, depth of liquidity information -otherwise known as visibility- has never been and never will be an issue for traders using ECNs. Through the limit order book, investors can view depth and size of interest on both sides of the market for any stock at any time. Despite its much self-touted initiatives to improve transparency and communication of market depth information, the NYSE has done nothing but give participants on the floor of the exchange another unfair advantage while moving further from an open and easily accessible market and quotation structure.

In May of this year the NYSE announced that it had begun providing depth of interest and conditions indicators to floor participants. By distributing this market information to floor participants and their customers only, the NYSE has effectively recreated the two-tiered market, which existed prior to 1996. An essential concept of the national market system was "...to make information on prices, volume, and quotes for securities in all markets available to all investors." Recent efforts by the NYSE have created a less reliable public quote and a more fragmented market. A purely negative and from the SEC's standpoint, unanticipated effect, partially resulting from decimalization. Of course, the fix is quite obvious and simple. The NYSE must openly display and distribute its market data to all interested participants at a fair price. Don't hold your breath.

A recent report from the NYSE states that decimalization has hurt exchange based trading due to a degradation of the inside market liquidity. In effect, by dramatically increasing the number of pricing levels available at which to place an order, the inside market is no longer a collection of interest within a sixteenth or greater of any price. With the relatively new penny or sometimes sub-penny trading levels, the inside market size for issues quoted on the exchanges or Nasdaq has experienced a significant degradation of market visibility, often hiding pending interest under a relatively insignificant 100 share order. Because the traditional exchanges have refused to deliver true depth of interest information to all participants, decimalization has resulted in a public quote that is less reliable that just one year ago.

A Liquid Market
Liquidity is essential for any market's success and survival. Further aided by decimalization and an innovative open market data structure, ECNs have realized impressive growth in this key area.

With the alternative trading systems or ECNs poised to reap the majority of the benefits from just about any change in the regulatory environment fighting exchange isolationism, the SEC has many a future battle on its hands. While the Nasdaq has been supportive rule changes facilitating fair market access for ECNs, the NYSE has dragged the SEC through the mud with respect to competitive issues. The established stock exchange has good reason to fear. In recent years numerous new share-matching systems have emerged, in aggregate grabbing significant market share from both the Nasdaq and NYSE. In fact, today the U.S. equity ECNs account for roughly 35 percent of all Nasdaq and 5 percent of all NYSE listed volume. This compares to 24 percent and 3 percent of the Nasdaq and NYSE listed volume respectively just one year ago.

Clearly a relatively simple advance technologically, senior officials at Nasdaq were reluctant to make the change. In seeking a one year delay in the implementation of decimalization, Nasdaq's chief information officer, Gregor Bailar, went as far as to say, "... because daily transaction loads have surpassed 2 billion shares, well ahead of Nasdaq forecasts, the capacity of (our) systems cannot handle the burden of converting and displaying stock quotes in decimal increments." It must have been hard to say that with a straight face. The real issue at hand was that the SEC was effectively asking specialists and market makers to give up some of their historically large trading spread revenues which went from a minimum trading increment of 1/16 to one cent or less, up to an 83 percent reduction.

No need to shed any tears for the traditional exchanges and markets. Both the Nasdaq and the much older NYSE have reaped huge rewards and enjoyed monopolistic control of all US equities trading for years while still maintaining tight control of some key systems, effectively preventing a truly fair competitive environment. The fact that these relatively new share-matching systems have had such a significant market penetration so quickly ranges from astonishing to unbelievable. Just a mere five years ago, nobody would have predicted the competitive market landscape, which exists today. Like a chapter right out of Christensen's The Innovator's Dilemma, the Nasdaq and especially the NYSE have failed to recognize the disruptive technology introduced by ECNs. Not surprising considering the difficulties the Nasdaq had in converting their own systems to decimals.

The Future of Trading
Rapid success speaks volumes as to the efficiency and attractiveness of ECNs as the order entry and execution venue of choice for many segments of the trading community. Each incremental change in the regulatory environment which promotes fair competition, broad access to market data and investor protection (supposedly they all do) directly benefits our capital markets - slowly breaking up the old boys club and their antiquated market structure. Regardless of the competitive issues, decimalization is an important and necessary change in support of the national market system concept, protecting the retail investor and specifically calling for a more unified market through information sharing, consistent pricing and quote dissemination.

Clearly the established exchanges and markets have the most to lose and conversely ECNs the most to gain under just about any exchange related regulatory change. Decimalization is just one in a series of steps which will help level the playing field for all investors, helping promote a truly open market system. Despite this unfriendly competitive landscape, the alternative trading systems or ECNs have and continue to challenge regulators to bring regulation in line with modern market technology. What's most impressive is that ECNs have and continue to gain market share from both the NYSE and Nasdaq at an impressive rate while operating under many unfriendly and archaic regulations enacted before their birth. Similar to starting a new electric utility company and effectively compete prior to deregulation.

Supported by regulatory change, equity ECNs are gaining market share at an eye-popping rate. Given the SEC's continued, yet often ineffective, efforts to improve the competitive landscape for all U.S. markets, the ECNs will likely continue their aggressive land grab operation. As ECNs have proven, innovation can overcome even the most challenging regulatory hurdles to give investors the transparent market of stocks all investors petition for. Decimalization is just one regulatory step closer to a level playing field for both the retail investor and the ECNs.

Brooks McFeely is the founder, president and CEO of MidnightTrader, Inc. (www.midnighttrader.com), a provider of news, data and market analysis focused on the after-hours markets, and an aggregator of trading data from the major Electronic Communication Networks (ECNs).