	Background

In 2000, in response to calls from Congress, SEC directed U.S. stock and  options markets to change from quoting equity securities and options in  fractions of a dollar, such as 1/16th, to quoting in decimals. However, even before the transition to decimal pricing, some  stocks were trading in increments of less than the MPV, such as 1/256th of a  dollar. According to SEC staff, data on the extent to which subpenny  increments are used to quote securities across all U.S. equity markets are  not routinely reported or readily available. SEC staff  also conducted a study of the use of subpennies in trading that took place  between April 21 and 25, 2003, and found that subpenny trades accounted  for about 13 percent of trades in Nasdaq stocks, 10 percent of trades in  American Stock Exchange stocks, and 1 percent of the trades in NYSE  stocks. According to SEC staff and  market participants with whom we spoke, subpenny quotes are used  primarily by professional traders, such as day traders or traders for hedge  funds, to gain a competitive price advantage over other traders. However,  some ECNs that were allowing their customers to use subpenny quoting  more widely have significantly curtailed the number of stocks that could  be quoted in subpennies. Market Participants Cited Advantages and Disadvantages to Subpenny Pricing

Although some market participants saw benefits to subpenny pricing, most  cited various disadvantages to the use of subpenny quotes. Some market  participants said subpenny quoting allowed traders to raise the priority of  their orders. According to market participants, many broker- dealers do not accept orders from their customers in subpenny  increments, and so the average investor generally cannot access the  subpenny quotes. These traders find that their  orders go unexecuted or have to be resubmitted when other traders step  ahead of them by quoting a better price in increasingly small amounts. Recent SEC and Nasdaq studies of subpenny trading found that most  trades executed in subpenny increments clustered at prices 1/10th of a cent  above and below the next full penny increment, suggesting that subpenny  quotes were primarily being used to gain priority over other orders and  were not otherwise the result of natural trading activities. SEC’s Proposal to Ban Subpenny Quoting Appears to Have Widespread Support

SEC’s proposed rule to prohibit market participants from pricing stocks in  increments of less than one penny appears to be widely supported. According to the staff, banning subpenny pricing should  also reduce the extent to which limit orders lose priority because of  subpenny pricing, thereby preserving incentives to display limit orders,  which are an important source of liquidity for the markets. Most market participants we have contacted to date and most commenting  on SEC’s proposal appear to support a ban on subpenny pricing for stocks  priced at more than one dollar. However, other market participants and other commenters opposed SEC’s  proposal to ban subpenny quoting. Several of the organizations that  opposed a ban said that subpenny quotes allow traders more ability to  improve the prices they offer to others. A ban could also reduce  incentives for other market participants to invest in innovative  technologies. GAO’s Review of the Impacts of Decimal Pricing Is Ongoing

At the request of this Committee’s Subcommittee on Securities and  Investment, we are conducting additional work to review the impact of  decimal pricing on the securities markets, securities firms, and retail and  institutional investors. In addition, we plan to conduct research and analysis using a  comprehensive electronic database of quotes and trades that have  occurred on U.S. stock markets. Observations

Because we are continuing to review issues relating to decimal pricing, we  do not have definitive conclusions on subpenny pricing at this time.
Why GAO Did This Study

In 2001, U.S. stock and options markets, which had previously quoted prices in fractions, began quoting in decimals. Since then, various positive and negative effects have been attributed to the transition to decimal pricing. As part of this transition, the major stock markets chose one penny ($.01) as the minimum price variation for quoting prices for orders to buy or sell. However, some electronic trading systems allowed their customers to quote in increments of less than a penny (such as $.001). The use of subpenny prices for securities trades has proved controversial and the Securities and Exchange Commission (SEC) has proposed a ban against subpenny quoting for stocks priced above one dollar across all U.S. markets. As part of ongoing work that examines a range of issues relating to decimal pricing, GAO reviewed (1) how widely subpenny prices are used and by whom, (2) the advantages and disadvantages of subpenny pricing cited by market participants, and (3) market participants' reactions to SEC's proposed ban.

What GAO Found

Data on the extent to which market participants are quoting in subpenny increments across all U.S. equity markets are not routinely reported or readily available. However, studies of limited scope conducted by regulators and one market found that subpenny prices were not widely used. For example, a study done by the Nasdaq Stock Market in 2001 of Nasdaq stocks found that subpenny increments were used in less than 15 percent of the orders that specified a price (limit orders). Currently, the major markets do not allow subpenny quoting but a few electronic trading systems that match customer orders do. On electronic trading systems, professional traders (such as those employed by hedge funds) use subpenny quotes to gain a competitive price advantage over other orders. However, many market participants GAO interviewed cited numerous disadvantages to the use of subpenny quoting. They argued that subpenny quotes primarily benefit the professional traders who subscribe to market data systems displaying subpenny prices and who use fast systems to transmit their orders to take advantage of such prices. As a result, most investors do not benefit from subpenny quotes because they do not use these systems and because many broker-dealers do not accept orders from their customers in subpenny increments. In addition, participants said that subpenny quotes allow some traders to step ahead of others' orders for an economically insignificant amount. They said this discourages other traders from submitting limit orders and reduces overall transparency and liquidity in the markets. Based on the work GAO has conducted to date, including a limited review of comments on SEC's proposal to ban subpenny quoting, most market participants support SEC's proposed action. However, some organizations opposed to the ban said that it could reduce the ability of traders to offer better prices and stifle technological innovation and reduce market participants' incentive to invest in better systems. Although some electronic trading systems supported the ban, others indicated that the decision to use subpenny quotes should be left to market participants who, as technology advances, may increasingly find subpenny quotes more useful than they do today. In addition to reviewing subpenny pricing, GAO continues to review the broader impacts of decimal pricing on markets, securities firms, and investors. As part of this work, we plan to conduct original analysis using a comprehensive database of trades and quotes from U.S. markets to identify trends in quoted spreads, clustering of quotes and trades across certain prices, and other potential changes since decimal pricing was introduced.