Have the NYSE Specialists Rigged the Game?
Charles V. Zehren
September 28, 2003
Have recent events at the New York Stock Exchange left you confused? Don't be. Money and power are involved, and that's most of what you need to know when it comes to understanding the ways of Wall Street.
For at its core, the fate of the world's most important financial market now rests on the outcome of a looming showdown between regulators and the Big Board specialists.
In the course of more than seven decades, these elite floor traders, who match buyers with sellers in the NYSE's centuries- old auction system, have successfully avoided reform. Theirs is a lucrative franchise that they want to protect.
Last year pretax operating profit margins for specialists ran between 35 and 60 percent, making their business "more lucrative than other financial service firms," said Brian Becker of the Washington, D.C.- based consulting firm Precision Economics.
What's more, within the culture of the exchange, the specialists wield plenty of clout. Just look at the role they played in chairman Richard Grasso's wrenching departure. Grasso censured and fined one of the most powerful specialist firms, LaBranche & Co., for not cooperating in a broad probe of specialists' practices. A LaBranche spokesman said there was no connection. But LaBranche executives turned on Grasso and joined the campaign that resulted in his departure.
In their defense, specialists say intense competition from other exchanges guarantees they will offer good prices. They also note that the switch to quoting stock prices from fractions to decimals has cut into their profits. "As messy as the specialist system looks like, it works," said James Angel, an associate professor at Georgetown University's McDonough School of Business.
Nevertheless, the specialists' enemies still see a golden opportunity to act amid the post-Grasso chaos. Their goal is to reduce or eliminate the role of the specialists, rely more on the electronic matching of orders, and "commoditize" the business of swapping shares.
This is especially the case for big institutional investors and traders from giant Wall Street firms who are keen on making more money by lowering their trading and execution costs.
At the same time, politicians like Elliot Spitzer and regulators like the Bush administration's Securities and Exchange Commission Chairman William Donaldson (himself a former NYSE head) sense that America seems in no mood to cut the Big Board some slack after living through a bear market, corporate accounting scandals, Wall Street research frauds, mutual fund machinations and the news of Grasso's $187.5 million pay package. Everything's on the table when it comes to reforming the NYSE, Donaldson says.
So if in the months ahead a compelling case can be made that the specialists have rigged the game, there's a good chance the regulators could take concrete steps to limit their power and overturn seven decades of NYSE self-regulation.
Operating from posts on the floor of the exchange, the specialists see and touch every trade - even large electronic orders. They typically orchestrate buying and selling in five to 10 stocks. In all, there are seven firms employing 443 people who "specialize" in more than 2,800 stocks. Companies listed on the exchange choose which specialist they want to make a market in their shares.
NYSE rules state that specialists must maintain a "fair, competitive, orderly and efficient market," treating all customer orders the same, while striving for smooth changes in price. Putting their own money on the line, they have the duty to balance supply and demand, line up buyers with sellers, show the best bids and offers, and monitor and process electronically routed orders.
But the system also expects specialists to trade for their own accounts, stepping in to buy and sell shares when no one else will. While the specialists are required to place and execute all customer orders ahead of their own, the critics say this gives them an unfair advantage. That's because the specialists know ahead of time what the supply and demand of a particular stock will be at some point in the future.
Consider what happens if a high-volume stock is in great demand. Specialists can execute all the orders to buy that stock at $20. But then they can jump in and buy for their own accounts at $20.125, knowing that additional demand coming through the pipeline will push the stock far higher, creating a virtually risk-free profit.
The SEC is also investigating whether specialists trade for their own account when buyers and sellers are matched up naturally. This practice, called "trading ahead," can occur when specialists have an order in hand from an investor to buy a certain stock, but set that order aside and buy the stock themselves. The specialists then make money as the stock's price rises when they complete the order for the investors. The investors wind up paying more than they would if the specialists had not traded ahead.
Another big part of specialists' job is to "cushion" the market, acting as the buyer or seller of last resort by stepping in to sell shares when demand is high and the price is soaring, and to buy shares when supply outstrips demand and the price is tumbling. The Big Board insists that specialists buy falling stocks. And the exchange says they use all sorts of high-tech means to make sure. But the critics counter that such assumptions defy human nature. They say that when a stock is crashing the specialists do what any red-blooded stock trader would do - they step out of the way.
Angel offered a more nuanced explanation. "Specialists are not required to catch a falling knife. They are required to maintain a fair and orderly market," he said. "It's hard to define what that is, but they know it when they see it."
Whether cold computer-driven systems will replace specialists remains to be seen. Trading is an art, not a science, and investors should have a choice of markets, the specialists say. During the high-tech rout, some investors complained they couldn't unload their crashing shares.
Specialists say that doesn't happen at the NYSE, where for better - and maybe sometimes for worse - there's always a human being, standing in one place, at an appointed time, ready to make a market.
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