Decimalization all seemed so perfectly sensible. Stocks in the US used to be quoted in fractions: halves, quarters, eights, sixteenths and even thirty-seconds of a dollar were the fractional prices paid for equities bought and sold on the US exchanges. The rest of the world had long since switched to decimal pricing, and with ever smaller increments being quoted for US stocks too (sixty-fourths anyone?) the pressure was on to rationalize the system. No more fractions and prices for equities could be expressed in dollars and cents, just like virtually everything else. The changeover took place in April 2001.

The Nasdaq market relies on "market makers," which are big institutions who intermediate between buyers and sellers on the market. They make their money by selling the stocks at a slightly higher price than they buy them: this is called the bid-ask spread. There had been much criticism of market makers and the high spreads that were quoted on many Nasdaq stocks, and decimalization was supposed to bring spreads down. And down they have come. In fact, they have come down so far that the profitability of making markets in smaller stocks is no longer viable, or so claims Nasdaq CEO Wick Simmons. He says that the decision by some big market makers like Merrill Lynch to withdraw from smaller stocks proves the point, and he now says that decimalization was a horrible mistake. What's worse, this makes access to the trading of smaller stocks more difficult, hurting both small investors and small companies.

So is this a classic Hayekian case of unintended consequences? I'm not so sure. The erosion of the bid-ask spread is a classic case of a more efficient market. The bowing out of some players is also a market response; you can't force people to engage in unprofitable business. (Well, you can, but it's not a good idea). So thus far what we're seeing is the market changing participants' preferences. Those who find no utility in making markets in small stocks will leave, and have their place taken by competitors who think they can make a buck doing so. It's also worth bearing in mind that decimalization took place at while the big Internet Bubble was deflating, and all Wall Street firms have fallen on tough times since then. Trading volumes aren't what they used to be, and small investors' appetite for small cap tech stocks is way down too. So perhaps Merrill Lynch's decision to exit the market making business in small caps is more related to the bear market than to decimalization. It would be interesting to see some data on other market-making exchanges around the world (couldn't find hard data on this).

We'll have to see how this pans out. Based on the evidence I have seen thus far, I'm not willing to say that decimalization is at fault here. If many players exit the market-making business in small caps then spreads will start to widen again as a illiquidity premium will have to be paid. As supply goes down, prices (i.e. spreads) will go up, which will attract players until the market reaches a new equilibrium. No need to panic yet. We'll announce the proper time to panic on the PA system.