To become more compatible with overseas markets, the U.S. securities industry is considering a plan to convert equities and options from fractions to decimals in three phases starting in July.

In Phase 1, to take place July 3 through Aug. 4, 30 to 40 securities will trade in increments of a nickel. In Phase 2, from Aug. 7 through Sept. 29, all securities will begin trading in nickel increments. From Oct. 7, all securities will trade in penny increments.

Like the Y2K issue, decimalization will require the analysis, change, and extensive testing of millions of lines of computer code. But the objective of the Y2K effort was to avoid disruption, whereas decimalization may have lasting business implications even if all changes are implemented correctly. The most significant are likely to be a sharp rise in message traffic and a reduction of pricing spreads in the U.S. equities markets.

Firms should immediately address how decimalization will affect their customers and the profitability of their equities and options businesses, as well as the ability of their technical infrastructures to process the additional volume.

Without careful planning and management of the change process, firms may stumble. Overlooking less obvious activities such as capacity planning and process redesign could restrict an institution's ability to process the anticipated high volume of quotes and trades even though the program code has been repaired. This in turn could cause an unexpected flood of failed trades, which would disrupt the entire equities market.

Recent studies estimate that quote volume for the U.S. equities markets could increase 100% to 300% once decimalization is fully implemented. Some industry observers believe that investors will change their trading strategies to take advantage of the decreased minimum price variation. Investors are expected to request more quotes as they wait for a stock price to change by that one additional increment before submitting a trade order. This strategy will probably trigger an increase in the volume and frequency of trades, orders, and cancellations, as well.

Experts are concerned that the order processing systems that generate these messages and the networks that transport them may not be able to handle the transactional increase, especially on high-volume days. When equities prices were changed from eighths to sixteenths in 1997, doubling the number of price points, there was a 14% increase in the number of New York Stock Exchange trades for the same volume of shares. There was also a proportionate increase in quotes and other message types throughout the industry.

The U.S. securities industry experienced a significant strain on its processing systems and communication infrastructures. The coming change from nickels to pennies will increase the number of price points fivefold. Firms' trade-volume-processing capacity would need to increase by at least 70% if the same growth ratio holds true.

Another expected result of decimalization is narrower spreads. Proponents estimate that decimalization will save investors billions of dollars annually. However, a narrowing of spreads may mean lost profits for dealers.

Quote spreads have been a topic of intense scrutiny in the securities industry for some time. The Securities and Exchange Commission has found in the past that traders have held spreads high in order to increase their profits. Once the industry has converted to decimal pricing, traders stand to lose revenue as they did following the 1997 change from eighths to sixteenths. Decimalization may leave dealers with only a penny or two profit on each share. How traders will make up for those losses remains to be seen, but competing for more trade volume and reducing costs to maintain profitability are two likely strategies. If, as some expect, easier-to-understand prices and lower commissions prompt more investors to trade, traders may realize a net benefit.

Higher quote volume and narrowing spreads will change the economics for most companies involved in U.S. equities. As a result, some firms may choose to reassign staff to focus on highly visible functions such as customer support and adjustments. Others may adjust to decimal pricing by implementing new marketing or call-center strategies or by focusing on improving operational efficiency and technical infrastructure capacity.

The economic change is likely to spur some firms to evaluate how decimalization will affect related business and technical issues, such as market segmentation, outsourcing strategies, software package options, and the use of technologies such as middleware, the Internet, and supporting architectures. Choices that were not cost-justified previously may be quite practical in a post-conversion world.

As the July deadline draws near, one thing is certain: Every company that wishes to remain in the equities market must address how decimalization will affect it. The transition cannot be avoided unless a firm decides to exit the business.

Beyond remediating code, installing decimal-friendly packages, and analyzing desktop applications, a comprehensive program for successfully changing to decimal pricing should encompass such elements as business strategy analysis and comprehensive project planning, which in turn requires capacity planning, process redesign, performance diagnosis, and testing.Critics have argued that decimalization should be postponed to allow for a post-Y2K recovery period. However, the proposed conversion schedule leaves firms with little time to prepare. The months ahead will be filled with recoding and testing to ensure that the U.S. equities industry is prepared to begin the switch in July. Firms must address the most critical business and technical issues now to ensure a smooth transition. Even those institutions with programs under way should assess their progress to identify areas in need of improvement while time remains to react. Mr. Plotkin is senior manager and Mr. Schweitzer is senior consultant at Arc Partners in New York

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