Critics say human frailties taint NYSE
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By Greg Farrell, USA TODAY
As the New York Stock Exchange (news - web sites) is being forced to take the closest look ever at its business practices, some of its biggest customers are calling for one of the most radical changes in the Big Board's 211-year history.
Interim Chairman John Reed is still putting finishing touches on a package of reforms to restore credibility following a scandal involving extravagant NYSE pay packages. Some of the USA's largest money management firms and pension finds are saying those changes should include scrapping or reconfiguring the essence of the NYSE trading system: the open auction model run by specialists.
"Our primary problem with the trading floor is that it's ostensibly anti-competitive because of its rules to protect the specialists," says Scott DeSano, head of global equity trading at Fidelity Investments, the mutual fund giant that represents 19 million investors.
In a day when computers are a staple of nearly every aspect of business and investing, the NYSE sets itself apart from its competitors because all of its transactions are still handled by people: the specialists who, as auctioneers, are responsible for matching buyers and sellers.
But specialists are also able to trade on their own behalf, knowing which way a stock is trending. And therein, critics say, is why the time-honored NYSE trading system is flawed.
"In the biggest, deepest market on the planet, I don't understand why there has to be someone who has an advantage over everyone else," DeSano says. "All we're trying to promote are free, competitive markets."
DeSano, as well as the head of the powerful California public employee retirement system and other institutional investors, wants the NYSE to switch to electronic communication networks (ECNs), like those used by Nasdaq and Internet trading platforms Island and Archipelago. The reason: ECNs match trades by computer, so there's no possibility of a specialist jumping into the middle of a trade for his own gain.
"There's a huge value-added to the ECNs," says Ted Oberhaus, director of equity trading at Lord Abbett. "This is not the imminent demise of the NYSE, just the inevitable loss of market share."
That kind of talk would have been considered blasphemy on Wall Street just a few months ago. If capitalism were a religion, its holiest shrine would be the NYSE. Like the Vatican (news - web sites), the exchange is housed in a fortress of a building. Its trading floor, where buyers and sellers trade billions of dollars each day, is the cathedral.
And just like the Catholic Church, the NYSE even had a pope. At least until last month, when its chairman, CEO and infallible leader Richard Grasso was forced to resign following the revelation that the exchange was going to give him a $188 million payday.
Now, in the wake of disclosures that Grasso and his top lieutenants were pocketing multimillion-dollar salaries, Reed is trying to reform the institution.
The specialists and the floor brokers they work with, all of whom own valuable seats in this exclusive club, want Reed to clean up the NYSE's management operation and usher in an era of transparency.
In general, the seat owners were pleased with Grasso's ability to preserve the NYSE's position as the world's premier stock exchange, but they were aghast when they learned that Grasso and his board of directors had funneled so much of their money into the pockets of management. In particular, the news that Grasso was awarded a $5 million bonus for his efforts to get the NYSE up and running again after Sept. 11 has angered members who worked equally hard in the days after the terrorist attacks.
But with Grasso gone, NYSE members face an emboldened enemy in the ideological war over whether their human auction system is superior to the ECNs. Institutional investors like DeSano have met with Reed to ask that he be open to changes on the way the Big Board is run. But DeSano admits that there's a huge clash of value systems between the two sides.
"It's tantamount to extreme right, right-wing Republicans and extreme left, left-wing Democrats," he says. DeSano and others view the NYSE as a kind of Tammany Hall, a clubby operation that generates mountains of money for its members and employees at the expense of John Q. Public.
DeSano says revelations about the size of the pay packages awarded at the NYSE show something is out of whack. "The money came out of the members' pockets," he says.
How the specialist system works
The root of the problem, critics maintain, is the specialist system that is unique to the NYSE.
Under this system, every one of the Big Board's 2,750 stocks is assigned to an auctioneer, or specialist. The auctioneer is physically stationed at a booth, or kiosk, on the floor of the exchange, where he provides bid and offer prices to interested parties, either matching buyers with sellers or dipping into his own stockpile to trade with brokers.
But the NYSE specialist has unique opportunities and responsibilities that separate him from other traders: He knows all the bids and offers coming in, so he can guess where the stock price is heading, and he's responsible for keeping trading "fair and orderly."
It is that unique position that irks institutional buyers. Under the guise of keeping markets "fair and orderly," specialists can step in between a buyer and seller, inserting themselves into a process where a buyer or seller might have to compromise, and netting a profit because they know where the market is probably heading.
The specialists, as well as NYSE management, call this process "price improvement." They argue that, if a buyer is bidding $20 a share for a block of stock, and a seller is asking $20.03 (but will settle for less), when the specialist steps in and buys the stock for $20.01, the "price improvement" helps the seller.
But institutional investors don't see it that way. "We don't want price improvement," declares DeSano. "When someone's getting an improved price, somebody else is getting disenfranchised."
Last-minute intervention by specialists or other bidders often causes institutional buyers like Fidelity to lose out, or pay more for their shares.
Robert Fagenson, head of the U.S. operations of specialist firm Van der Moolen, and a member of the NYSE's board, says that most of the time, it isn't the specialist who steps in to bid $20.01 to trump the institutional investor; four out of five times, it's another bidder. But Fagenson is aware of the complaints and says the NYSE is responding to the needs of institutional investors. "We are taking aggressive steps to address the primary concerns of these customers," he says. Fagenson points out that the NYSE is testing a new electronic service that will allow big buyers like Fidelity to pair off with big sellers without last-minute small-volume bidders crashing the party by offering a penny more per share.
"We think it is appropriate for us to rapidly examine and put in place a rule change that will enable that institutional customer who placed the $20 bid to be rewarded," says Fagenson, noting that such rule changes would have to be approved by the Securities and Exchange Commission (news - web sites).
Profiting on inside knowledge?
At the heart of the complaints regarding specialists is that they make money trading in stocks because they have full knowledge of supply and demand.
Decades ago, when there were scores of individual specialists on the floor of the exchange, not everyone made money. The 1987 crash drove many small specialists out of business or into the arms of acquirers. As trading volume grew dramatically in the '80s and '90s, the need for capital forced many firms to consolidate.
Today, there are five large specialist firms that handle the bulk of NYSE trading, and two smaller firms that bring up the rear. Of the five, three specialist firms disclose their profits. In 2002, LaBranche & Co. made $166 million on revenue of $453 million; Fleet Specialist made $169 million on revenue of $325 million; and Van der Moolen made $153 million on revenue of $251 million. Critics point to those profits, in an off year for Wall Street, as proof that specialist firms make money at the expense of other players in the marketplace. In fact, the NYSE is investigating the five major specialist firms for irregular trading activity, and the results of its findings are expected soon.
Michael LaBranche, CEO of LaBranche, says his firm's profit was generated on more than $3 trillion worth of trading. Van der Moolen's Fagenson points out that trading profits have declined dramatically in the past three years. "Complaints about excessive profits are no longer valid," he says. Adds LaBranche: "On a per-transaction basis, our margins are razor thin. We are the low-cost provider of liquidity."
LaBranche and other NYSE floor members challenge the notion that ECNs are superior. "There's no data to support claims that all electronic markets are more cost efficient and better for investors," he says. "The data simply doesn't exist."
Institutional investors favor ECNs because they can trade large blocks of stock quickly and anonymously. On the NYSE floor, once the word gets out that there's a major buyer or seller in the marketplace, prices start fluctuating. That's good for small investors, looking for the best price, but bad for the big guys and day-traders. "What's the hurry?" asks Bernard Herold, who's had an NYSE seat for 32 years. "It's better to be smarter than faster."
Acknowledging some of the system's imperfections, LaBranche cautions tampering too much with the marketplace: "The (NYSE) is not perfect, but it's the best system out there. You want to improve on (its) benefits ... and the good things that it does."
DeSano is willing to go halfway, asking for incremental change. "We understand that nothing happens overnight. This should be effectively staged."
Other Big Board veterans are confident that under new, responsive management, the NYSE will remain the biggest and best stock exchange in the world.
"The exchange has lasted through rascals, felons, wars, impeachments, recessions and assassinations," says John Jacobson. "In times of stress, nothing works better than the New York Stock Exchange." |
