NYSE 'specialists' may be too special to survive
Critics say they add little, often abuse information access
By Ben White, Washington Post, 12/7/2003
NEW YORK -- Bob Hardy works in a gilded factory on Wall Street where hired hands can make $150,000 even in a bad year.
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A Harvard MBA is not required. Nor is a sterling family pedigree. Traditional tickets to the top at Wall Street investment banks and brokerage houses mean little on the floor of the New York Stock Exchange, where Hardy and the 450 other "specialists" conduct trading in individual stocks.
Many specialists lack college degrees; some never finished high school. Instead, they rely on steady nerves, good memories, and fierce loyalty -- which critics have called a code of silence.
Hardy, who studied classics at the University of North Carolina at Chapel Hill, runs trading in a handful of international stocks.
"It's definitely more Elks Club than Union Club," Hardy said one recent morning as he prepared to open his trading kiosk after rising at 3:30 a.m. to monitor international markets and currency prices. "We've got MBAs and guys who didn't finish high school. It doesn't matter as long as you can make money."
Exactly how specialists make that money is the subject of much debate among securities industry regulators, members of Congress, and NYSE customers and competitors. Regulators say specialists used their unique access to pending buy and sell orders to improperly trade for their own accounts, costing investors around $150 million between 2000 and the end of 2002. Specialists deny these charges.
In the NYSE system, the last of its kind in the world, specialists essentially serve as auctioneers on the exchange floor.
Each is assigned to run trading in a handful of stocks, taking buy and sell orders both through the NYSE's computer system and from floor brokers, who gather around specialist trading posts looking to trade shares for their customers.
Under exchange rules, specialists must stand aside and let buyers and sellers meet at a mutually satisfactory price whenever possible.
But they are also allowed to trade for their own accounts and are, in fact, required to act as the other side of a trade when a buyer cannot find a seller or vice versa.
Critics, led by big mutual fund companies, pension funds, and some brokerage firms, would like to see specialists disappear, and have buyers and sellers meet exclusively through computer networks. Specialists add little value, these people say, and often abuse their access to proprietary information about the direction of the market.
Nonsense, say the specialists, who believe tales of their mendacity are grossly exaggerated and complain that they get little credit for their good works -- chiefly buying or selling stock when no one else will, smoothing volatility, and making sure buyers and sellers get the best possible prices.
"It's frustrating," said Linda Jay, a specialist with LaBranche & Co., one of five firms under investigation for alleged trading abuses. "There is such a huge misconception about what we do and the value that we add."
One day recently, for instance, Jay had an order to sell shares in Boykin Lodging Co., a real estate investment trust, at $8.83 and to buy at $8.88. She matched the orders at $8.85, giving the seller a "price improvement" of 2 cents and the buyer an improvement of 3 cents. This is how the system should, and usually does, work, specialists say.
Jay wound up at the NYSE through the advice of a family friend, who saw her working as a manager in a Newark restaurant on a Valentine's Day. There were hundreds of hungry patrons and nervous waiters zipping around in a panic. Jay managed that Saturday night smoothly, never losing her cool. The friend said she would be a natural at the frenzied exchange. Historically, "seats" on the exchange, which allow specialists to trade, were often passed down from generation to generation. But Wall Street historian Charles Geisst says that has become less and less the case.
"Generally speaking, those who are well born, who inherited seats, have become less interested in the business and have sold their seats or lease them out," he said. Of the 1,366 NYSE seats, about 950 are now held by lessees, according to an exchange spokesman.
Not that specialists don't need skills. At any given point they must keep scores of orders in their heads so they can quickly relay them to frantic floor brokers crowding around the specialists' trading posts. They must do instant price calculations and match incoming orders at breakneck speed.
Specialists also need a high tolerance for risk. In exchange for the ability to trade for their own accounts, specialists must take the other side of a trade when no one else will, keeping liquidity in the market and reducing volatility.
Hardy, the international stock specialist, recounted the many harrowing times he has been the buyer of last resort in his stocks, often seeing losses for his firm rise into the millions before buyers returned. When buyers do not return, specialists can be wiped out in a day. The 1987 crash, for instance, put a handful of specialists out of business.
And the dramatic rise in trading volume in the 1990s increased demands on specialists to put more of their own capital at risk every day, leading to consolidation in the industry. There are now just five big specialist firms and two small ones.
How much individual specialists take home from these profits is primarily conjecture. Specialist firms prize loyalty in their employees, and part of that loyalty consists of remaining tight-lipped about business matters. Several specialists, however, said they make at least $150,000 in a bad year and well over $1 million in a good year.
Exchange critics say specialists sometimes make this money at investors' expense, using information on pending orders to make can't-miss bets for themselves. Specialists scoff at an estimate by the Securities and Exchange Commission and the NYSE that such practices cost investors around $150 million over a three-year period.
They say a large portion of the alleged customer "losses" were based on orders specialists never saw because they arrived while a specialist was "reporting" a previous trade. When a specialist's screen is in "report mode," the order book is frozen. When specialists come out of report mode, several new orders may have lined up for prices that may no longer be available. Most of the time, specialists say, they help buyers and sellers find the best prices.
But critics say that no hard data prove specialists actually improve prices for investors, that the only way for specialists to make significant money is to trade for themselves at the expense of investors, and that they have been protected by lax self-regulation at the NYSE.
These arguments came to a head when the exchange revealed in September that it had awarded former chief executive Dick Grasso a pay package worth $187.5 million. To many, this was proof that the NYSE operates as a mutual protection society, with members paying executives lavish sums in return for having their interests protected.
Specialists and floor brokers say they've heard it all before. Could regulation be improved? Yes. Could they make the system more transparent to people not on the floor? Absolutely. But will the NYSE's 211-year-old auction system vanish? Unlikely, they say. "We've gotten the standing eight count plenty of times," Cashin said, using a boxing term for the time a referee takes to decide if a dazed boxer can continue. "But we've always gotten off the canvas."
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