Trading costs  are generally measured differently for retail and institutional investors. Investors’ Trading Costs Have Declined Since Decimalization, but Reduced Market Transparency Has Caused Firms to Adopt New Trading Strategies

Trading costs for both retail and institutional investors fell after the  implementation of decimal pricing and the corresponding reduction in tick  size. Total trading costs declined by about 53 percent for  NYSE stocks, falling from about 33 cents per share in early 2001 to about  15.5 cents (fig. The various sources  of data we collected and analyzed indicated that after decimal pricing and  the 1-cent tick were implemented in 2001, the volume of shares shown as  available for sale—or displayed depth—on U.S. stock markets declined  significantly. Some Stock Intermediaries Have Experienced Lower Profits since Decimalization, but Other Factors Have Contributed to the Declines

Although overall securities industry profits have returned to levels similar  to those in the past, some market intermediaries, particularly those broker- dealers acting as exchange specialists and NASDAQ market makers, have  been significantly affected by the implementation of decimal pricing. Sharp declines in the  overall level of prices in the stock market, the growing use of trading  strategies that bypass active intermediary involvement, and heightened  competition from ECNs and other electronic trading venues have affected  revenues and profits. Many of the market  intermediaries but fewer than half of the institutional investors we  contacted favored this move. Broker-dealers Revenues from NASDAQ Activities Have Also Fallen since Decimal Pricing Began

Decimal pricing has also generally negatively affected the profitability of  firms that make markets in NASDAQ stocks. One major impact on  firms’ revenues since 2000 has been the sharp multiyear decline in overall  stock market prices. In addition, officials  at several firms noted that such a pilot is unnecessary because institutional  investors have already adjusted to penny ticks. For example, an  official of a large market-making firm stated that decimalization in the  options market was “a small ripple in a huge pond.”

		Although Decimal Pricing Not Significant, Key Measures of Options Markets’ Quality Have Improved

Although decimal pricing’s impact was not seen as significant, various  measures used to assess market quality have shown improvements in U.S.  options markets in recent years. Traditionally, trading on U.S.  options markets had occurred on the floors of the various exchanges. In response to the reduced displayed market depth,  institutional investors are splitting larger orders into smaller lots to reduce  the market impact of their trading and accelerating their adoption of  electronic trading technologies and alternative trading venues. Methodology for GAO Analysis of Trade and Quotes Data

To assess the impact of decimal pricing, one of the activities we performed  was to analyze data from the New York Stock Exchange (NYSE) Trade and  Quote (TAQ) database spanning the 5-year period between February 2000  (before the conversion to decimal pricing) and November 2004 (after the  adoption of decimal pricing) to determine how trading costs for retail  investors changed and how various market statistics changed, such as the  average number of shares displayed at the best prices before and after  decimalization. Tick size (or minimum price increment)

The smallest price difference by which a stock price can change (up or  down).
Why GAO Did This Study

In early 2001, U.S. stock and option markets began quoting prices in decimal increments rather than fractions of a dollar. At the same time, the minimum price increment, or tick size, was reduced to a penny on the stock markets and to 10 cents and 5 cents on the option markets. Although many believe that decimal pricing has benefited small individual (retail) investors, concerns have been raised that the smaller tick sizes have made trading more challenging and costly for large institutional investors, including mutual funds and pension plans. In addition, there is concern that the financial livelihood of market intermediaries, such as the broker-dealers that trade on floor-based and electronic markets, has been negatively affected by the lower ticks, potentially altering the roles these firms play in the U.S. capital market. GAO assessed the effect of decimal pricing on retail and institutional investors and on market intermediaries.

What GAO Found

Trading costs, a key measure of market quality, have declined significantly for retail and institutional investors since the implementation of decimal pricing in 2001. Retail investors now pay less when they buy and receive more when they sell stock because of the substantially reduced spreads--the difference between the best quoted prices to buy or sell. GAO's analysis of data from firms that analyze institutional investor trades indicated that trading costs for large investors have also declined, falling between 30 to 53 percent. Further, 87 percent of the 23 institutional investor firms we contacted reported that their trading costs had either declined or remained the same since decimal pricing began. Although trading is less costly, the move to the 1-cent tick has reduced market transparency. Fewer shares are now generally displayed as available for purchase or sale in U.S. markets. However, large investors have adapted by breaking up large orders into smaller lots and increasing their use of electronic trading technologies and alternative trading venues. Although conditions in the securities industry overall have improved recently, market intermediaries, particularly exchange specialists and NASDAQ market makers, have faced more challenging operating conditions since 2001. From 2000 to 2004, the revenues of the broker-dealers acting as New York Stock Exchange specialists declined over 50 percent, revenues for firms making markets on NASDAQ fell over 70 percent, and the number of firms conducting such activities shrank from almost 500 to about 260. However, factors other than decimal pricing have also contributed to these conditions, including the sharp decline in overall stock prices since 2000, increased electronic trading, and heightened competition from trading venues.