Has Decimalization Been a Success?

Saturday, April 9th marks the tenth anniversary of decimalization in the United States' equity markets. Since the change to decimal pricing, stocks have been traded in pennies instead of the traditional increments of one-eight or one-sixteenth of a dollar.

At the time of the change, and in the decade since, regulators and market commentators have routinely applauded the move to decimals and its perceived benefits, including a reduction of the fees borne by investors, smaller bid-ask spreads and an overall increase in liquidity. In fact, most of the academic literature that has examined the post-decimalization decade has confirmed this view. Less studied and more abstruse, however, is some of the harmful second-order effects the change might have encouraged. In fact, a closer examination suggests that decimalization's record is more of a mixed bag.

Certainly, decimalization is only one part of a broader, more complex and evolving market landscape. Unfortunately, that market has grown increasingly out of touch with the needs of long-term investors. Together, regulatory change and technological advancement have supported a Wall Street model that now caters increasingly to high-frequency trading accounts. In light of these changes, it is not surprising to observe companies reluctant to IPO their shares or investors distrustful of the market and its structure.

While reduced transaction costs are generally seen as a boon to consumers, in the case of decimalization, the benefits might come at some cost. As spreads have disappeared, market making firms have seen little economic incentive in continuing to provide research and liquidity support to a low-margin, high risk enterprise. Despite increasing volumes, the revenues of market makers and specialist firms have been decimated and the number of firms conducting such activities has shrunk by more than half.

The move to the 1-cent tick has also reduced market transparency and the depth of bids and offers at any particular price point. As a 2007 GAO study found, fewer shares are now regularly displayed as available for purchase or sale in U.S. markets. As a result, it is more difficult for market participants to move large stock positions. In response, institutional investors have increasingly moved to quantitative and algorithmic trading models - now typically apportioning large orders into smaller lots.

Not surprisingly, as a recent Forbes article observed and the Flash Crash illuminated, decimalization has contributed to a market where "volatility is on the loose, as more trades take place but with smaller increments of stock sold per trade." Market transparency is also suffering, as traders are turning to so-called "dark pools" to access liquidity. Developments resulting in increased volume with decreased transparency seem particularly troubling in light of the Commission's perpetual complaint that it lacks the staff and resources to monitor the market effectively.

When it comes to investments, higher front-end costs are not all bad, as they serve as an effective check on the short-term behavior of market participants and can discourage speculation in favor of investment. By raising the cost of transactions and encouraging buy-and hold behavior, regulation might mitigate boom-and-bust cycles and support a healthy investment culture.

As markets become frictionless, however, a once proud market for the "moving and storage" of stocks becomes dominated by those with a "moving mentality" and a short term investment horizon. In such an environment, investors attending to the intrinsic value of a stock and companies focused on long-term returns for shareholders are routinely trampled by a herd of speculators betting on a stock's next tick. And, with such massive numbers of participants engaged in speculative activity, capital suffers a poor allocation. The booming ETF business, for example, has been a major beneficiary of 1 cent spreads, as hedging and creation costs have diminished. But, ETFs have also brought homogenized markets and have interfered with the proper allocation of capital.

The fundamental job of an economy - and, more precisely, its capital markets - is to allocate its scarce capital efficiently. When an economy functions optimally, capital is invested in sectors expected to generate high returns, and withdrawn from sectors with poorer prospects.

A well-functioning and efficient financial market and its associated institutions improve the capital allocation process, and thus contribute to economic growth. As an engine of growth, no capital market has enjoyed the remarkable record of the United States. But, the capital allocation process has been seriously interrupted by the sequence of events that started with decimalization. Whenever we alter that market's structure - especially when we leave it to the machinations of algorithmic traders, dark pools and unapologetic speculators - we must be careful not to put its continued success in jeopardy.