(August 2) – “A penny here, a penny there. And before you know it, we’re talking real money,” writes Randall Smith in today’s Wall Street Journal.
“The move to trading in decimals instead of fractions will crimp the profit margins of one of Wall Street’s biggest cash cows. But while it adds up to millions in reduced trading profits in the short term, securities-industry executives believe they can more than make up for the cutback with higher volume down the road.”
“New York Stock Exchange Chairman Richard Grasso warned last month that the changeover to decimals will have ‘a more dramatic economic impact on the [securities] business than the unfixing of commission rates 25 years ago.’ During a visit to Palo Alto, Calif., on July 18, Mr. Grasso added the shift ‘will implode spreads and implode commissions [and change] the business models of many of my largest customers.’ “
“A trading spread is the difference between the bid and asked price for any given stock, and dealers generally attempt to pocket it as profit after subtracting costs. The reduction in spreads should occur as stocks begin trading in increments of a penny; right now they often trade in increments of 1/16 or 1/8 of a dollar. That means that instead of increments as low as 6.25 cents (the dollar equivalent of 1/16), a stock’s price could move in ticks as low as one cent — a reduction of 84%.”
“Although that might suggest that spreads will shrink by a comparable amount, Wall Street executives say the impact won’t be that dramatic because some stocks already trade at spreads of less than 1/16, and because not all stocks will go to a penny spread with the advent of decimalization.”
“Bernard L. Madoff, chairman of the securities firm bearing his name, a specialist in processing trades for other firms, estimates that decimalization eventually may halve market-makers’ spreads on the average stock in the Standard & Poor’s 500 stock index to roughly five cents a share from a current level of about 10 cents.”
“While spreads on some of the most actively traded stocks may shrink to a penny, Mr. Madoff says, spreads on some less actively traded stocks may actually increase as some market makers pull back from trading such riskier, less-liquid issues. Wall Street executives also anticipate that higher volume will naturally follow the lower trading costs, as it has in the past when trading costs fell. ‘Yes, you will lower the trading profits per transaction of certain segments of the industry, but that would be more than offset by the increased volume,’ Mr. Madoff adds.”
“Thomas Joyce, co-head of global electronic equity trading at Merrill Lynch & Co., agrees that spreads might contract by 40% to 50% in the aggregate. But he predicts that, after “a period of transition” during which spread revenues might decline, ‘there will be a lot more trading. As in the past, when spreads declined, we expect volumes to increase which will partially offset the narrower spreads.’ “
“Several industry executives note that when spreads were halved from 1/8 to 1/16 a few years ago, market makers took it in stride despite predictions of doom similar to Mr. Grasso’s. Trading volume in stock markets has soared thanks both to lower commissions and a rising market, and the specialist firms that trade stocks on the floor of the New York Stock Exchange ‘never made more money,’ as one executive puts it.”