Helen Paxton, Director of Communications
Rutgers Faculty of Management
201/648-5177 fax 648-1006
Email: [email protected]
Stock Markets Can Save in Decimals
When Rutgers' David Whitcomb, Professor of Finance,
testified before Congress last month, he didn't make any friends among
securities dealers. His thesis was, in a phrase, that the American
practice of quoting stock prices in fourths and eighths, rather than in
actual cents, enriches large dealers at the expense of ordinary
investors -- by as much as $2.5 billion a year!
The U. S. is the last industrialized nation that still uses
fractions rather than decimals. The practice goes back to the 1790s,
when, computers being still far in the future, the use of fractions made
calculating prices easier, especially because the "hard" currency was
Spanish pieces-of-eight.
But the reason the practice has survived so long into the
computer age, Dr. Whitcomb told Congress, is that securities dealers
and specialists -- who control the so-called "Self Regulatory
Organizations (NASD and the stock exchanges) -- make money from
fractional pricing, and they don't want it changed.
Here's a super-simplified explanation of how it works.
When somebody places a "market order" -- like "Buy 200
shares of IBM at market," and IBM is quoted at 107-1/2 bid-
107-3/4 offered -- then the dealer handling the order is supposed to
scout around and find someone willing to sell at the best (i.e., lowest)
price.
The problem is the bid-offer spread -- here, one quarter.
Dealers can find somebody willing to sell to them at or near the bottom
of the range and then can sell to their client at the top of the range --
and pocket the difference.
It's far, far more complicated than just this. Prof. Whitcomb's
ten pages of testimony before Congress (actually the House
Subcommittee on Finance) goes into details of "payment for order flow,"
"adverse selection," "natural equilibrium," and other esoterica. But the
basic point is that decimalization will narrow the spread and thus will
permit investors, rather than dealers, to keep most of the profits from
buying and selling their stocks.
No, decimalization would not put dealers out of business.
The "equilibrium bid-ask spread" (a concept that Dr. Whitcomb
introduced in a 1981 paper in the Journal of Political Economy) would
continue to be large enough to permit dealers -- who perform a valuable
service -- to be paid well. All that would end would be the hidden
subsidy that they have been getting for many years.
And no, the conversion wouldn't be a huge undertaking. In
fact it's the other way around. Decimals are the language that
computers already understand; it's the fractions that require special
programming.
And finally, no, decimalization is not "communistic," as one
big dealer called it, nor will it "cause the marketplace to dry up."
Instead it is, Dr. Whitcomb says, just a matter of letting public
investors, professional traders, and dealers compete on a level playing
field, and of encouraging price competition, the backbone of the free
enterprise system.
It will, moreover, bring the U. S. into line with what's going on
in other countries. And it will make investing more attractive to more
people, with the result that it will cause the market to grow, to
everyone's benefit.
DAVID K. WHITCOMB is an authority on the microstructure of stock
exchanges around the world. The author of three books and about 40
articles on financial and economic subjects, he has taught at Rutgers
since 1975.
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