“Decimalization” – the pricing of stocks in dollars and cents instead of fractions – lauded by proponents to be a good thing for investors when it was adopted by the U.S. stock markets in early 2001, is under fire. Critics say it costs institutional investors big. But in a study co-authored by Venkatesh Panchapagesan at Washington University’s Olin School of Business, direct institutional trading costs appear to have declined by about 23 basis points (roughly 5 cents a share) after decimalization. In economic terms, this decrease translates to an average monthly savings of about $133 million in institutional trading costs, the study finds.
In the paper, “Has Decimalization Hurt Institutional Investors?,” Panchapagesan, and co-authors Sugato Chakravarty of Purdue University and Robert A. Wood at the University of Memphis, examine the effect of decimalization on institutional investors using proprietary data from Plexus Group, which advises buy-side institutional investors on trading costs and handles about a fifth of all dollar trading volume in U.S. equity markets.
“Our results are surprising in light of an oft-repeated, and increasingly louder, complaint among professional traders that liquidity is hard and expensive to find in a post-decimal trading milieu,” said Panchapagesan. “Though there is significant change in order routing practices overall, we find an increased usage of alternate brokers for easy-to-fill, smaller orders and full service and independent research brokers for larger orders that are difficult to fill.”
The switch to decimalization reduced the minimum “spread” or gap between buy and sell prices from 1/16 – the equivalent of 6.25 cents – to a penny.
“While retail investors welcomed the idea of trading in finer price increments, institutional investors were more concerned about its adverse impact on liquidity, “said Panchapagesan. “But it appears that overall market liquidity has not changed though displayed liquidity has gone down.”
Using a sample of institutional order executions in NYSE stocks, Panchagesan and his co-authors show that total trading costs have declined by about 5 cents a share or about 23 basis points after decimalization. This decrease translates to an average monthly savings of about $133 million in institutional trading costs.
Panchagesan notes that many on Wall Street would like to see trading prices increased to minimum increments of a nickel while others would have decimal trading repealed outright, with a return to fractional trading. SEC chairman William Donaldson commented publicly recently that decimalization “needs to be looked at.” Meanwhile, the Senate Finance and Banking Committee is expected to hold hearings on the effects of decimalization soon.
“These findings have important regulatory implications, especially in light of growing support among Wall Street firms to replace decimals with nickels,” said Panchagesan.