End of the road or new beginning for NYSE Specialists?

Peter Bennett

“The market structure in which we operate is subject to changes that could adversely affect our financial condition and results of operations. Most notably, the NYSE’s recent proposed changes in its automated trade execution system and the SEC’s recent proposed structural changes in the US equity trading markets may have an adverse effect on our business”.

From LaBranche & Co LLC, 2004 10-K Report.

Introduction

By most measures NYSE is the world’s number one venue for equity listing and trading. NYSE attributes its success in no small part to the system of Specialists and floor based auctions that have endured with little change for over a century. However the system is now threatened by a combination of factors including regulatory and technology change, as well as self-inflicted scandal involving five of the remaining seven NYSE Specialists firms.

We explore the characteristics of this venerable system, the key factors that have come to threaten it, and the prospects for its survival.

The origins of NYSE and the Specialist system

“We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever any kind of Public Stock, at a less rate than one quarter percent Commission on the Specie value of, and that we will give a preference to each other in our Negotiations. In Testimony whereof we have set our hands to this 17th day of May 1792. ”

Wall Street was marked out in the middle of the seventeenth century as a barrier of brushwood that guarded the southern tip of the Dutch colony of New Amsterdam. Designed to keep Indians out and livestock in, it was to be the first of many ‘walls’ erected to protect the Street.

The place was to be named Wall Street by the British in 1685, and under their influence it became the centre of a rapidly-growing port city, populated by merchant's homes and offices, coffee shops and insurance brokers.

NYSE has its origins in the 1792 Buttonwood Agreement drawn by up by 24 prominent brokers handling the bonds that Alexander Hamilton floated to replace the debt incurred by the American Revolution.

Almost immediately after its launch in late 1790, the treasury scheme was followed by speculation, scandal, and a financial crisis that provoked proposals for an intrusive regulation of Wall Street brokerage business by the New York State Legislature. The Buttonwood Agreement was Wall Street's response. It was embroiled in issues that have endured to this day, in particular the tensions between self and public regulation, between self interest and the public good, between restrictive practices and open competition. Another enduring theme is reoccurring scandals or abuse of the system, followed by forceful regulatory intervention by government agencies.

The NYSE system of trading began as a call market[1]. To this day a call auction is used to open the NYSE market for each traded security. Around 1870, following the conclusion of the Civil War and a rapid rise in commerce, trading volumes increased and the market mechanism gave way to continuous open outcry auctions[2] conducted at trading posts. It is about this time that the Specialist system had its origins.

As is often the way with enduring invention, the NYSE Specialist system came about not by the careful design of wise men, but by accident. The story goes that one Mr Boyd, a NYSE broker, managed to break a leg in the year of 1875. Whilst he was recuperating he decided to conduct his business from a chair located at the Western Union trading post thus ensuring he was at the centre of things – for Western Union, along with Railroads, were the hot stocks of the time. Whist so strategically seated it became the habit of other brokers who scurried from trading post to trading post to leave their orders with Mr Boyd to work on their behalf. For this service he received a share of the commission. Thus originated the Specialist model.

The first Specialists were primarily brokers, handling limit and stop orders for other exchange members, while such members focused on the hot trading posts.

By 1910 most floor members, other than those representing commission firms, followed the practice of moving to any post which then seemed attractive. There were a considerable number of Specialists in round lots and odd lots, who would do brokerage and dealing for their own account in other issues if time or opportunity afforded itself. The dealer function of Specialists in their specialty stocks became more prominent after 1910, both as a result of other exchange members' need for a continuous market in stocks, particularly in those that were thinly traded, and through the increased opportunities that were available to Specialists to make profits by trading for their own accounts due to the sizeable amount of order flow routed to them. By 1935 most of today’s Specialist trading rules had been put in place by the SEC (Securities and Exchange Commission) and NYSE. The Specialist system had also been adopted by most regional US exchanges.

The current Specialist system at the NYSE

Today’s Specialist orchestrates open outcry auctions in particular stocks at designated trading posts. Depending on current interest in the securities being traded at a particular post, it may or may not be surrounded by a rowdy crowd of brokers. The trading posts are festooned with electronic screens. It is fair to say that the electronics are a facade that cloaks an arcane system of trading.

A key display, the Display Book, is angled towards the Specialist and his staff. It shows details of all the orders electronically routed to the exchange in his speciality stocks, plus those lodged with him from the floor. Limit orders are displayed in price/time priority, and the display resembles the public limit order books used by most other exchanges and the ECNs for automatic order execution and display of market depth.

In the NYSE case the information on the display is largely not for public consumption, save for the top of the book prices, nor for the most part do the orders on the book execute automatically. Instead execution is controlled manually by the Specialist in conjunction with interactions with the trading crowd and injection of his own interest into the book. Executable buy and sell customer orders can appear on the Display Book at the same time. In such instances, Specialists will manually ‘pair off’ or cross the buy and sell orders.

In the general scheme of things small orders tend to be routed directly to the Display Book, larger orders are placed with floor brokers for working through the crowd and really large block trades are done upstairs and merely reported at the appropriate trading post.

Stocks are allocated to Specialists by a process administered by the NYSE Allocation Committee. Although this has not always been the case, listed stocks are allocated to particular Specialist firms on an exclusive basis.

Specialists operate in the dual capacity of broker and dealer and their dealings are governed principally by the Securities Exchange Act of 1934 and NYSE Rules 92.

In the NYSE's continuous two-way agency auction market, Specialist firms are responsible for the quality of the markets in the securities in which they are registered. A Specialist is expected to maintain, insofar as reasonably practicable, a ‘fair’ and ‘orderly’ market. A ‘fair’ market is deemed to be free from manipulative and deceptive practices, and affords no undue advantage to any participant. An ‘orderly’ market is characterised by regular, reliable operation, with price continuity and depth, in which price movements are accompanied by appropriate volume, and unreasonable price variations between sales are avoided.

Specialists have two primary duties: performing their ‘negative obligation’ to execute customer orders at the most advantageous price with minimal dealer intervention, and fulfilling their ‘affirmative obligation’ to offset imbalances in supply and demand. Specialists participate as both broker (or agent), absenting themselves from the market to pair executable customer orders against each other, and as dealer (or principal), trading for the Specialists' dealer or proprietary accounts when needed to facilitate price continuity and fill customer orders when there are no available contra parties to those orders.

The Specialists’ various roles can be classified as follows:

Auctioneer – Because the NYSE is at its heart a floor based auction market, bids and offers are competitively routed there by investors. These bids and offers must be posted for the entire market to view so that the best bid and offer price is always maintained. It is the job of the Specialist to ensure that all bids and offers are reported in an accurate and timely manner, that all marketable orders are executed, and that order is maintained on the floor.

As an auctioneer, the Specialist continually shows the best bids and offers throughout the trading day. These quotes are electronically displayed through the NYSE quote. The Specialist is also responsible for opening the market in each security he is responsible for, and resumption of trading following a halt. Both are handled in a manner similar to a call auction market. At the opening, buy and sell orders have accumulated since the last transaction, and the Specialist has the responsibility to set a ‘fair’ price which clears all market orders.

The Specialist may have considerable discretion in setting an opening price depending on the number of orders in his book, on his own willingness to participate, and on his ability to find other traders at the opening. Since about 1982, Specialists have been assisted at the opening by the Opening Automated Report Service (OARS). This service stores all orders that are to receive the opening price, and provides the Specialist with information on the imbalance between buyers and sellers.

Agent or Broker – With the advent of continuous trading on the NYSE in the 1870s, it became natural for busy floor traders to leave orders with other traders who would specialise in particular securities, and receive a commission for doing so. Until the post-World War Two period the most important activity of the Specialist appears to have been his brokerage function.

Typically orders entrusted with the Specialist are limit orders at prices above or below the current market price.

Such limit orders increase the depth and liquidity of markets because buy limit orders below the market keep prices from falling too much and sell limit orders above the market keep prices from rising too much. Under NYSE rules, the book of limit orders narrows the market bid-ask spread since the Specialist is required to quote the book if the book’s price is superior to his own bid or offer.

Today’s Specialist accepts limit orders relayed predominantly by direct electronic routing to the Display Book or by floor brokers gathered in front of the Specialists' trading posts – the crowd.

The Specialist’s negative obligation binds him to execute customer orders at the most advantageous price with minimal dealer intervention. They are prohibited from trading for their dealers' accounts ahead of pre-existing customer buy or sell orders that are executable against each other. When matchable customer buy and sell orders arrive at Specialists' trading posts they are required to act as agent and cross or pair off those orders and to abstain from inter-positioning as principal or dealer.

Catalyst – As the Specialists are at the centre of things on the market floor in direct contact with the buyers and sellers of particular securities in the crowd, and with ready access to the flow of orders into the Display Book, they are ideally placed to act as a catalyst by seeking out recently active investors in cases where the bid and offers can't be matched and continuous trading ceases.

Principal or Dealer – It is in this role that the Specialist can stand to gain or lose most money. Usually public order meets public order without Specialist principal participation. When this is not the case Specialists are obliged to put their capital at risk to ensure trading continuity and to minimise price volatility.

If buy orders temporarily outpace sell orders, or conversely if sell orders outpace buy orders, the Specialist is required to use his firm's own capital to minimise the imbalance. This is done by buying or selling against the trend of the market until a price is reached at which there is a reasonable balance in public order flow. The Specialist must effect these transactions when their absence could result in an unreasonable lack of continuity and/or depth in its specialist stocks. The Specialist is not expected to act as a barrier in a rising market or as support in a falling market, but must use its own judgment to try to keep such price increases and declines equitable and consistent with market conditions.

Careful inventory management is obviously a key requirement given such obligations. At other times the Specialist is free to market make and to seek to earn money on the spread or inventory positions within the bounds of NYSE trading rules. The Specialist quotes bid and ask prices inside those on the book if he believes he can make profits at these prices.

Thus the Specialist firm’s decision to buy or sell shares of its Specialist stocks as principal for its own account may be based on obligation or inclination. For example, the Specialist firm may be obligated to buy or sell its Specialist stock to counter short-term imbalances in the prevailing market, thus helping to maintain a fair and orderly market in that stock. At other times, the Specialist firm may be inclined to buy or sell the stock as principal based on market conditions. In actively-traded stocks, the Specialist firm continually buys and sells its Specialist stocks at varying prices throughout each trading day. The Specialist firm’s goal and expectation is to profit from differences between the prices at which it buys and sells these stocks. In fulfilling its Specialist obligations, however, the Specialist firm may, at times, be obligated to trade against the market, adversely impacting its profitability.

In trading as principal the Specialist is bound by the following rules:

• A Specialist must first satisfy a customer’s market buy order before buying any stock for its own account. Similarly, a Specialist must first satisfy a customer’s market sell order before selling any stock for its own account.
• A Specialist must first satisfy a customer’s limit order held by it before buying or selling at the same price for its own account. A Specialist may not have priority over any customer’s limit order. A Specialist, however, may buy or sell at the same price as a customer limit order as long as that limit order is executed first.
• The Specialist does not charge commissions for trades in which it acts as a principal.
• Except in some circumstances in less active markets, the Specialist may not, without permission from an exchange official, initiate destabilising trades for its own account which cause the stock price to rise or fall. Effectively this means that when dealing for his own account a Specialist, except in unusual circumstances, is required not to sell on a direct minus tick and not to buy on direct plus tick. 

The rise of the ECNs

At the time of writing (April 2005) The New York Stock Exchange has announced an unprecedented merger with Archipelago Holdings Inc. The move will transform the NYSE from a member-owned utility to a publicly traded, for-profit company. NYSE’s regulatory function will be operated separately from the combined NYSE Group.

This move follows the announcement early in 2004 of a crash programme to automate trading in the Specialists’ Display Book for orders earmarked for automatic trading. Under the scheme, the Specialists will also be expected to update their trading interest in the book automatically using algorithmic trading techniques. The automated tier will run in conjunction with the traditional floor-based auction market.

Shortly after NYSE’s bombshell, Nasdaq announced that it was to buy Instinet’s INET. Inaugurated in 1971 and generally regarded as one of the more innovative US market places, Nasdaq has been fighting for its life, facing a very real threat of bypass by ECNs. To ward off the threat, Nasdaq has managed to re-engineer itself as a sort of super ECN and has demutualised. The making of the new market structure called Super Montage gave rise to considerable controversy, and involved a great deal of horse trading between Nasdaq and its participants, with the SEC acting as mediator.

How has all this come about, and what does it mean for the NYSE Specialists?

In my mind the story starts with a tiny start-up founded in 1969. Instinet was the first financial intermediary to introduce systematic and automatic matching of customer orders purely on an agency basis using a computerised system programmed by just a handful of clever engineers. The service was offered to US institutional investors and matching was performed anonymously to reduce market impact costs.

Under the leadership of Bill Lupien, trading on Instinet was to ignite when Nasdaq market makers were invited onto the system. They used it effectively as an inter-dealer broker. This happy accident resulted in dealer orders which effectively provided narrower spreads than those displayed on the public markets. This in turn attracted institutional order flow. Critical mass, the most difficult thing for a new entrant to achieve in the trading venue business, had been achieved!

In 1985 Nasdaq introduced SOES and Select Net. These developments helped Nasdaq broker-dealers such as Herzog Heine Geduld and Bernard L Madoff to provide automated execution services in Nasdaq listed and third market stocks[3], on a principal basis, to retail clients at new lower cost levels. Such services provided for best execution guarantees as well as price improvement through ‘payment for order flow’ models. The concepts were adopted and refined by Knight Securities who positioned themselves as a wholesale provider of best execution services to the new breed of Internet-enabled eBrokers in the mid-1990s. By combining market making with sophisticated rule-based order handling machinery designed to guarantee best execution, and riding the dotcom boom, Knight Securities quickly rose to become a leading Nasdaq player.

By the mid 1990s the SEC was getting worried about the trading volumes executed away from the regulated markets. The finer spreads available on Instinet were now becoming an issue for public concern. Also the Instinet model was being cloned by a growing army of ECNs. Evidence was also surfacing that Nasdaq market makers were colluding to maintain artificially wide spreads, in tick sizes of a quarter (25 cents) in the public market. The handling of customer orders was also causing concern, particularly the practice by Nasdaq market makers of not displaying and trading ahead of customer limit orders.

Several measures were to be introduced to apply to all US securities markets. The so called Manning rules, approved by the SEC in 1994 prohibited dealers from trading ahead of customer limit orders. The SEC was also to mandate pre-trade transparency obligations.

The obligations took the form of Order Handling Rules implemented in 1997 which require a market maker, exchange or Specialist that receives a customer limit order better than its own published quote to:

• execute the order;
• incorporate the limit order price into its published quote; or
• pass the order on to an ECN for public display and matching.

The latter was to be accomplished universally under the SEC ‘ECN Display Alternative’ that provided for ECNs to act as an intermediary on a voluntary basis in communicating to the relevant market centre the best bids and offers entered by their dealer customers.

Later, in 1998, the SEC followed through with Regulation ATS (Alternative Trading System). This sought to increase ECN regulation and required that they register as an ATS operating as a market intermediary under Regulation ATS, or as an exchange regulated under the 1934 Exchange Act. The new rules included a pre-trade transparency rule that required ECNs to make public their ‘top of book’ prices. They were also are required to provide all registered broker-dealers with access to displayed orders.

In drafting Regulation ATS the SEC revisited the definition of ‘exchange’ to include ATSs, observing that:

 “They are increasingly performing many of the functions typically carried out by registered exchanges and are being used by many market participants as the functional equivalents of exchanges.”

The SEC Order Handling Rules were to spur the development of ECN’s under the sponsorship of some of the big name intermediaries, and by the late 1990s they were springing up all over the place. The Instinet model was copied by players such as Island, Archipelago, REDIBook and Bloomberg TRADEBOOK, and they were accounting for an ever increasing amount of order flow in Nasdaq stocks. Also they were beginning to consolidate their liquidity pools via high bandwidth links. The situation was summed up, somewhat graphically, by Harold Bradley of American Century Investments:

“Already a number of ECN’s have built links around Nasdaq‘s SelectNet because that service is expensive and terribly unreliable. In some ways I view the current technology process as an embolus headed for the market’s heart. What the ECN’s are doing – driven by competition, efficiency, and free enterprise – is major bypass surgery.”

For the first time since its inception, the Nasdaq system that consolidated and displayed competing market maker quotes was in mortal danger. Frank Zarb, then Chairman and Chief Executive Officer of the National Association of Securities Dealers Inc (NASD) was to say at a Senate banking Committee meeting exploring the role of ECNs:

“I guess I sum up the answer as to why we have ECNs as the fact that the national stock exchanges, and I’m not only talking about ours, but the exchanges around the world haven’t been keeping pace with the needs of the market.” 

In an attempt to head off the threat posed by a system of linked ECN’s Nasdaq had mooted the idea of introducing a Central Limit Order Book (CLOB) into the quote-driven system of competing market makers. Needless to say, the idea was met with outcry and derision by the ECNs. The Nasdaq market makers were not too happy about the idea either.

Nevertheless Nasdaq’s plans were to be given added momentum by an SEC Concept Release published in February 2000.

The purpose of the release was to give notice of filing of a proposed rule change by the New York Stock Exchange Inc. to rescind Exchange Rule 390. This had operated to preclude NYSE member firms from internalising their agency order flow by trading as dealer or principal against it. The rule's restrictions on off-board trading had been widely criticised as an inappropriate attempt to restrict competition among market centres. As a quid pro quo for rescinding the rule, NYSE requested the SEC to adopt an industry-wide customer price protection rule-voicing particular concerns over market fragmentation. Little were they to know that this would later be forthcoming, but in a very unwelcome guise. (I am referring to Regulation NMS more of which later.)

At the same time the SEC itself raised other concerns regarding market fragmentation generally noting that:

“Investor interests are best served by a market structure that, to the greatest extent possible, maintains the benefits of both an opportunity for interaction of all buying and selling interest in individual securities and fair competition among all types of market centres seeking to provide a forum for the execution of securities transactions?”

The SEC put forward several proposals for comment designed to address the perceived problems. These included:

“As a means to enhance the interaction of trading interest, the Commission could require that all market centres expose their market and marketable limit orders in an acceptable way to price competition.”

Another suggestion involved an enhanced national market linkage system:

“To assure a high level of interaction of trading interest, the Commission could order the establishment of a national market linkage system that provides price/time priority for all displayed trading interest.”

With considerable alacrity Nasdaq was to seize the moment to promote its own solution to the issue of market fragmentation. Speaking at a hearing conducted by the Senate Banking Committee on the Future of Securities Markets on February 29, 2000, Frank Zarb aired Nasdaq’s latest proposals. Now dubbed Super Montage, Zarb was at pains to explain the proposal was not a limit order book:

“Because this proposal is ground breaking, not all will understand it. Before I describe it, I also need to describe what it is not. Super Montage is not a Consolidated Limit Order Book...mandatory CLOBs and system wide time priority requirements do not effectively incorporate or incent the multiple market makers who now provide liquidity and immediate executions on Nasdaq, and who thus cushion the market when it is under stress?We believe the Super Montage is an important step to achieving greater centrality and less fragmentation in the marketplace while allowing competition to flourish. In essence, the proposal will build on Nasdaq’s strengths as a collector and aggregator of trading interests – the traditional role of a market. In addition, the Super Montage will be an inclusive model in that it will not favor or disfavor a particular business type – ECN, fully integrated market making firm, or wholesale market making firm?”

Behind the scenes NASD had already lodged with the SEC a series of proposed rule changes underpinning the Super Montage concept. The latest proposals now contained no mention of the contentious consolidated limit order book, but instead talked in terms of enhancements to the Nasdaq quotation montage to create a new venue for the display of trading interest, called the Nasdaq Order Display Facility, and an associated Order Collector Facility.

The ECNs however were quite clear that the proposed rule changes amounted to a Nasdaq CLOB in all but name.

An Instinet comment letter to the SEC, dated April 20, 2000 is illustrative:

“The Super Montage proposal would effectively use the NASD’s regulatory authority to create an inefficient, anticompetitive, mandatory central limit order book in the over-the counter (‘OTC’) marketplace”.

What was to follow was over a year of intense horse trading as NASD sought to satisfy all who had an axe to grind. All in all, the SEC received 104 formal comment letters. The intense effort by all concerned culminated in SEC approval of substantially amended Super Montage proposals in January 2001.

Launched in October 2002, Super Montage is a complex mix of dealer- and order-driven market mechanisms. The system has clear origins in previous Nasdaq trading systems and practices and continues to provide incentives for dealers to commit to quote obligations through order routing and processing concessions. It also provides several mechanisms for automated order display, routing and execution designed to provide incentives for ECNs and other market centres to display the contents of their order books centrally, and to use Nasdaq for order routing.

In the event the two biggest ECNs, Instinet and Island, elected not to participate in Super Montage. Instinet used the SEC-mandated Alternative Display Facility and Island elected, at the time, to link to the Cincinnati Stock Exchange (CSE).

The Super Montage story illustrates two things:

• the considerable and rapid reengineering that one of the world’s largest exchanges has been required to undertake to ward off a very real threat of bypass, and
• the difficulty in keeping the central market trading mechanisms competitive whilst protecting the interests of it members.

Not that many years ago, trading in US stocks could be divided fairly clearly into groups, each with its own particular mix of market centres. The traditional auction exchanges – NYSE and the American Stock Exchange (Amex) – dominated trading in their listed stocks, with some dealer participation on the regional exchanges and in the third market. Market Makers dominated trading in Nasdaq stocks.

Today the landscape has changed. According to SEC figures, automated quote-driven market centres such as Nasdaq's SuperMontage, the Archipelago Exchange, and Inet ATS, Inc. have captured more than 50% of Nasdaq share volume. For Amex stocks (of which approximately 39% of share volume now is represented by two extremely active exchange-traded funds – the QQQ and SPDR), Amex itself now handles approximately 27% of the volume, with the remaining balance split among Archipelago, Inet, and others. The NYSE has retained approximately 75% of the volume in its listed stocks but the writing is on the wall, and it is the SEC which is doing the writing!

The walls close in

On February 26, 2004, against a backdrop of rapid consolidation of Specialist firms, shrinking profits and scandal, the SEC launched a bombshell called innocuously Regulation NMS Proposing Release No. 34-49325.

The stated purpose of the release was to update some antiquated rules regarding the National Market System (NMS), and to take into account substantial changes in the markets services landscape, in particular a bifurcation in manual trading processes offered by the traditional floor-based exchanges (classified as ‘slow’ markets) and completely automated trading services being offered by the likes of the Archipelago Exchange and INET (classified as ‘fast’ markets).

Now it is was to be the turn of the NYSE and its system of Specialists – a manual or slow market – to come under the spotlight.

The National Market System has its origins in legislation going back to 1975. Starting with the elimination of fixed commissions in 1975, the SEC has initiated a host of regulatory changes designed to end restrictive practices and promote competition between market centres. In the same year amendments to the Exchange Act provided the framework for market structure in the US – a national market characterised by a system of interlinked and competing markets. Congress envisioned that competitive forces would shape the structure of markets, and granted the SEC broad authority to oversee the implementation, operation, and regulation of a National Market System.

On January 26, 1978, the Commission issued a statement on the National Market System calling for, among other things, the prompt development of comprehensive market linkage and order routing systems to permit the efficient transmission of orders among the various markets for qualified securities.

In March 1978, several exchanges, led by the NYSE, filed jointly with the Commission a ‘Plan for the Purpose of Creating and Operating an Inter-market Communications Linkage’, now known as the ITS Plan. This was subsequently to be put in place along with a system for consolidating and disseminating market information emanating from the various market centres.

By far the most controversial part of Regulation NMS concerned revisions to the Trade-Through rule[4]. In proposing the revisions the SEC noted:

“Changes in the equities markets in recent years have raised the issue of whether a trade in one market should be executed when a quote at a better price is displayed in another market. Rules limiting trading at an inferior price have been in place since 1978 in the markets for NYSE and Amex securities, but no such intermarket rules exist in the markets for Nasdaq securities. Over the years, dramatic changes have occurred in each of these markets, and trading in Nasdaq, NYSE, and Amex securities has spread across an increasing variety of market centres, including ‘alternative’ highly automated markets, many of which provide for almost instantaneous executions of matching buy and sell orders within their systems?

“The Commission therefore is proposing a rule intended to preserve the benefits of price protection across markets, while addressing the tensions in the operation of the current ITS trade-through rule. The proposed rule would require an order execution facility, national securities exchange, and national securities association to establish, maintain, and enforce polices and procedures reasonably designed to prevent the execution of a trade-through in its market. The proposed rule would apply to all incoming orders in ‘NMS Stocks’ – all Nasdaq, NYSE, and Amex-listed stocks – and to any order execution facility that executes orders internally within its market, whether or not that market posts its best bid and offer in the consolidated quote system.

“The proposed rule would have two major exceptions. One would allow customers (and broker-dealers trading for their own accounts) to ‘opt-out’ of the protections of the rule by providing informed consent to the execution of their orders, on an order-by-order basis, in one market without regard to the possibility of obtaining a better price in another market. The other exception would take into account the differences between the speed of execution in electronic versus manual markets by providing an automated market with the ability to trade-through a non-automated market up to a certain amount away from the best bid or offer displayed by the non-automated market”. (Emphasis added).

This distinction in the drafting between automated markets, like the Archipelago Exchange, and non-automated markets like NYSE clearly acts to the advantage of the automated markets.

No doubt sensing what was in the wind, the NYSE Board of Directors had approved in January 2004 a proposal to relax restrictions of the NYSE Direct+ automatic execution platform, and a rule change filing to this effect was to be lodged with the SEC in February 2004.

This was to be crucial in representing NYSE’s case at a public hearing on Proposed Regulation NMS on April 21, 2004.

At the hearing John Thain, freshly installed Chief Executive Officer of the NYSE, was to represent the NYSE’s position on the crucial Trade Through opt-out provisions thus:

“Weakening the trade-through rule, particularly the opt-out provision, is not in the best interests of US and global investors, be they minnows or sharks”.

He also made it plain his intentions regarding qualifying NYSE as a fast market:

“I am committed to making the New York Stock Exchange a fast market. Full stop, we're going to do that”.

In the event John Thain’s clear and forceful lobbying was to be remarkably successful. Soon after the public hearing the Commission was to issue a notice extending the comment period regarding NMS, and submitting further ideas for comment which indicated a substantial shift in position:

“The Commission is extending the comment period and publishing this supplemental request for comment to give the public a fuller opportunity to reflect the NMS Hearing in their comments on the proposals.

“A significant element of the NMS Hearing was the intention expressed by various representatives of exchanges with traditional trading floors to establish facilities in the coming months that will offer automatic execution of orders seeking to interact with their displayed quotations (‘Auto-Ex Facilities’).

“Panelists also emphasised that the essential element of an effective Auto-Ex Facility is an immediate automated response (i.e., one without any manual intervention) to the router of the incoming order.

“They stated that the response must be either that the order was executed (in full or in part) or that it could not be executed (because, for example, a prior incoming order already had executed against the displayed quotation). The exchange representatives acknowledged the challenges posed by developing an efficient hybrid market – one that integrates an active trading floor with an Auto-Ex Facility. They emphasised, however, that they were well advanced in their efforts and indicated that such facilities are likely to become operational within a time frame that could precede any potential implementation date for Regulation NMS, should the Commission decide to adopt the proposals.

“In addition, panelists at the NMS Hearing noted that existing order routing technologies were capable of identifying, on a quote-by-quote basis, indications from a market centre that a particular quotation was not accessible through an Auto-Ex Facility.

“The ability to display such a quotation potentially would give exchanges with trading floors the flexibility to integrate effectively the trading floor with an Auto-Ex Facility. Rather than being classified as ‘fast’ or ‘slow,’ markets would be allowed to offer choices to investors. In those particular contexts when a market's quotation was not accessible through an Auto-Ex Facility (for example, to provide an opportunity for the floor to generate additional price discovery or price improvement), the quotation would be identified as such and order-routers could respond accordingly. As discussed further below, the Regulation NMS proposals also could be drafted to reflect whether a quotation was, or was not, accessible through an Auto-Ex Facility. Competitive forces and the needs of investors, rather than regulatory classifications, would determine the relative success of various types of manual and automated trading facilities.

“The near-term prospect that quotations displayed in the NMS may be predominantly accessible through Auto-Ex Facilities, but with some flexibility for markets to offer investors the choice of manual trading, potentially has very significant consequences for the rules proposed under Regulation NMS. Some of the most difficult issues raised by the proposals, particularly those relating to trade-throughs, access, and market data, derive from the problem of accommodating both auto-executable and manual quotations within the NMS. These problems could largely disappear in the near future if NMS quotes become predominately accessible through Auto-Ex Facilities”.

In August 2004 NYSE was to file substantially reworked market automation proposals. At the press launch John Thain emphasised the value of the NYSE floor brokers and Specialists, whilst at the same time announcing a significant market automation programme:

“As we increase electronic trading, we want to preserve the unique advantages of the auction system.

“Floor brokers and Specialists create these advantages by adding human judgment, the opportunity for price improvement, and lower volatility on the Exchange. The human factor is particularly important at opens and closes, and during times of uncertainty, when earnings surprises or outside events disrupt the market.

“In our hybrid market we will provide for immediate, automatic execution against the best bid and the best offer to the extent of the displayed liquidity, without any restrictions on the frequency or on the size of orders submitted. At the same time, we will maintain the low volatility that is a prized feature of the Exchange.

“Specialists and floor brokers will continue to provide liquidity and make markets.

“Their interaction with the market will be both on the Exchange floor and electronic.

“However, at opens and closes, or when a stock would trade in a volatile manner, the market in that stock will convert to an auction mode. And there the Specialist will work with the broker to find liquidity and determine the right price for electronic trading to resume.

“Fully electronic markets cannot respond well to these types of events, and so prices whipsaw and investors get hurt.

“We will minimise such volatility”.

In November 2004, following comments that the Hybrid Market proposals were confusing and hard to understand, no doubt due in part to the haste in which they were prepared and in part by intense drafting input by the Specialists and floor brokers intent on protecting their interests, NYSE issued Amendment No 2 to the Hybrid Market Proposals.

In any event, the various filings and submissions seem to have had the desired effect. For in December 2004 the SEC was to publish re-proposed regulations regarding Reg NMS that were far less onerous for NYSE than the original. Given that NYSE was willing and able to automate its quotations, its quotes would receive Trade Through protection.

In terms of the Trade Through rule, the emphasis had now shifted from fast and slow markets as the differentiator for Trade Through protection to manual and automated quotations.

“The Commission believes that the insights of the commenters, as well as those of the NMS Hearing panelists, have contributed to significant improvements in the original proposals. Responding appropriately to these comments has caused the reproposed rules to differ in some respects from the rule text as originally proposed.

“As with the original proposal, the reproposed Trade-Through Rule would take a substantially different approach than the trade-through provisions currently set forth in the Intermarket Trading System (‘ITS’) Plan, which apply only to exchange-listed stocks.

“The ITS provisions are not promulgated by the Commission, but rather are rules of the markets participating in the ITS Plan. These rules were drafted decades ago and do not distinguish between manual and automated quotations. Moreover, they state that markets ‘should avoid’ trade-throughs and require an after-the-fact complaint procedure pursuant to which, if a trade-through occurs, the aggrieved market may seek satisfaction from the market that traded through. Finally, the ITS provisions have significant gaps in their coverage, particularly for large, block transactions (10,000 shares or greater), that have seriously weakened their protection of limit orders.

“In contrast, the reproposed Trade-Through Rule would only protect quotations that are immediately accessible through automatic execution. It thereby would address a serious weakness in the ITS provisions, which were drafted for a world of floor-based markets and fail to reflect the disparate speed of response between manual and automated quotations. By requiring order routers to wait for a response from a manual market, the ITS trade-through provisions can cause an order to miss both the best price of a manual quotation and slightly inferior prices at automated markets that would have been immediately accessible. The Trade-Through Rule would eliminate this potential inefficiency by protecting only automated quotations. It also would promote equal regulation and fair competition among markets by eliminating any potential advantage that the ITS trade-through provisions may have given manual markets over automated markets.

“?Reproposed Rule 611 would affirm the fundamental principle of price priority by limiting trade-throughs of protected quotations for all NMS stocks. A ‘trade-through’ is a trade at a price worse than a quoted price. To qualify for protection, a quotation would be required to be automated. The reproposed rule would not provide any protection for manual quotations?

“To qualify as an automated trading centre, the trading centre must have implemented such systems and rules as are necessary to render it capable of displaying quotations that meet the action, response, and updating requirements set forth in the definition of an automated quotation. Further, the trading centre must identify all quotations other than automated quotations as manual quotations, and must immediately identify its quotations as manual quotations whenever it has reason to believe that it is not capable of displaying automated quotations. These requirements are designed to enable other trading centres readily to determine whether a particular quotation displayed by a hybrid trading centre is protected by the reproposed Trade-Through Rule. Finally, an automated trading centre must adopt reasonable standards limiting when its quotations change from automated quotations to manual quotations, and vice versa, to specifically defined circumstances that promote fair and efficient access to its automated quotations and are consistent with the maintenance of fair and orderly markets.

“The reproposed rule does not contain a general ‘opt-out’ exception that would have allowed market participants to disregard displayed quotations. The elimination of any protection for manual quotations is the principal reason that this broad exception is not included in the reproposal”.

On April 6, 2005, the Securities and Exchange Commission approved Regulation NMS on a 3-2 vote. This included applying the Trade-Through rule across all markets, with no opt-out provision. Implementation will begin in April '06. An initial phase will include 100 stocks from each of the NYSE and the Nasdaq markets, and 50 from Amex, and will last until June '06.

There can be no doubt that Reg NMS has been instrumental in triggering unprecedented change at the venerable NYSE.

Before considering the impact of the changes on the NYSE Specialists it will be useful to review the Hybrid Market Proposals.

The NYSE Hybrid Market Proposals

First mooted early in 2004 the proposals have, as we have seen, been subsequently expanded and refined in two amendments filed on August 2, and November 8, 2004 respectively.

Amendment 1 was widely criticised for being obscure and lacking in important detail. A comment letter by Fidelity is representative:

“Our immediate reason for writing is to caution that the NYSE proposal, as filed, is written in a fashion that is so prolix that it seriously impedes the ability of investors and other interested persons to understand the proposal and thereby offer informed comments to the Commission”.

Junius W Peake, Monfort Distinguished Professor of Finance, Kenneth W. Monfort College of Business University of Northern Colorado, and long time advocate of a Public Limit Order Book Utility as a cheaper and better alternative to the NMS had this to say:

“The New York Stock Exchange proposed amendments to their Direct+ system are the technological equivalent of attempting to strap a jet engine onto a World War I Sopwith Camel biplane, and declaring it now to be a ‘modern’ airplane. They do nothing to further the development of a national market system. In fact they take it in a retrograde direction by adding almost unbelievable complexity”.

The Securities Industry Association (SIA) comments were more measured:

“While the SIA strongly supports the NYSE’s efforts to expand automation in its market, the current proposal is incomplete and lacks important details and concrete examples of how the system will operate in practice. We believe it is difficult to evaluate the effects of the proposal without more information. In fact, the market structure impact of this proposal is comparable to the Nasdaq Stock Market’s SuperMontage, which we note required numerous amendments in order to provide sufficient detail to elicit meaningful comment. Only with such additional information can we understand completely how the hybrid market will operate, and be assured that it contributes to fair and orderly markets, fosters competition among markets, and protects investors”.

Amendment number 2 answered to some extent this criticism and was usefully accompanied by numerous worked examples. By any measure, however, the filing is complex and runs to some 166 pages of rule changes, explanatory notes and examples.

The proposals involve expansion of the NYSE Direct+ system. At present, NYSE Direct+ provides optional automatic execution of limit orders up to 1,099 shares at the best bid or offer. There is also a prohibition against entering orders for the same account within 30 seconds. The average order-execution time is 0.78 seconds. NYSE Direct+ was introduced in phases beginning in December 2000, and was fully implemented in April 2001.

The Hybrid Market Proposals lift constraints on the size, timing, and types of orders that can currently be submitted via Direct+ and permit market orders and immediate-or-cancel orders to be eligible for Direct+. A new order type – an auction limit (AL) order – will provide the opportunity for price improvement with automatic execution. Market orders not designated for automatic execution will be executed in the floor-based auction market, where they will have an opportunity for price improvement.

Thus the automated facilities are intended to work alongside the current agency auction system and automatic trading will revert to manual trading when there are disruptions in continuous market operations or imbalances in order flow. In the normal course of things Specialists and floor brokers can be expected to interact with the market electronically. The floor-based auctions will also be available for investors seeking to work their orders via a floor broker to minimise market impact costs.

In the normal course of operations quotes will be automatically refreshed and will reflect the combined liquidity of the Display Book and the electronic interest of the broker crowd and the Specialist. Limit orders will be published in real time. The NYSE claims that this structure will facilitate the ability of floor brokers and Specialists to interact with supply and demand at the point-of-sale and to scale interest and provide price improvement to incoming electronic orders seeking liquidity.

Investors will have the choice of floor-based auction representation and the opportunity for price improvement over the published best bid and offer with market orders, and the new automated ‘auction limit’ order that will be processed in a way designed to replicate electronically the agency auction process.

Market orders designated for automatic executions and marketable limit orders will be executed automatically at the price of and to the extent of the size of the Exchange’s published bid or offer. The unfilled balance of such an order will sweep the book until it is fully executed, its limit is reached, or a liquidity replenishment point – a volatility moderator – is reached.

Investors who desire sub-second automatic execution will have access to the full breadth of the Display Book and floor liquidity. Floor brokers’ agency interest files will supplement liquidity beyond the published quote when investors choose to sweep NYSE liquidity. Liquidity providers outside of the published quote will be price-improved at the clean-up price, and liquidity takers will be price-improved based on brokers’ agency interest on behalf of customers, as well as Specialists’ electronic interest.

All quotes are subject to automatic execution, unless designated otherwise. Non-auto-ex quotes may be generated electronically when liquidity replenishment points are reached, or by the Specialist due to an order imbalance. A transaction, an update of the quote by the Specialist, or a timer-generated quote update will resume auto-ex ability.

According to NYSE, liquidity replenishment points (LRPs) are volatility moderators designed to promote fair and orderly markets. When an LRP is triggered, the quotation is not available for automatic execution and will be designated as such. At that point, the Specialist, crowd and off-floor market participants may enter orders to replenish liquidity on either side of the market.

The market will return to automatic execution mode when a trade takes place or a manual quote is entered. It will also move to automatic mode by default in 5 seconds if there is no residual after an LRP, or automatically in 28 seconds if there is a residual.

All better-priced bids and offers in other markets will be immediately accessed unless customers are provided the same price on the NYSE. All incoming orders from competing market centres will be automatically executed at the displayed best price.

Specialists will have the ability to systemically supplement the quote, determine price points where they want to provide liquidity by bidding or offering for their dealer account, and systemically match outgoing ITS commitments. This will give Specialists the ability to improve a sweep price or fill an order to facilitate a single-price execution.

Brokers will have the ability to place agency interest at varying prices at or outside the quote with respect to orders he or she is representing. That file will not be published in OpenBook, but it will be shown in the quote if it is the NYSE’s best bid or offer. The broker’s agency interest will have priority if it establishes the best bid or offer, will be on parity with other orders at its price, and can improve the price of a sweep order. The broker will be able to use this agency file in only one crowd at a time, and it must be cancelled if the broker leaves the crowd and before a broker trades verbally as part of the crowd.

The concept of the agency interest file has come in for some strong criticism

George Rutherfurd, Consultant, Chicago, Illinois observes:

“As I explained in my earlier comment, the NYSE’s proposed broker agency interest file is actually a hidden limit order book consisting of floor broker go-along parity orders that would deny executions to orders entered earlier in time on the public limit order book, or would result in partial executions of orders that would otherwise be executed in their entirety. Clearly, the effect of the broker agency interest file is to disincent the placement of orders on the NYSEs public limit order book, and to deny such orders as are placed the benefits of price/time execution priority that exist in every other marketplace of which I am aware. This is ugly stuff, a most unsavory accommodation of NYSE floor traders at the expense of the broad investing public”.

The Investment Company Institute has proffered the following:

“In our comment letter on the original hybrid filing, the Institute expressed concern regarding the lack of transparency of the broker agency interest file and the accompanying priority provided to a broker. Specifically, while the broker agency interest file, as originally proposed, would not be publicly disseminated, orders in that file would be executed on parity with investors’ orders placed on the NYSE’s Display Book, which are required to be displayed or the full size of the orders. Permitting this parity runs counter to the Exchange’s goal of providing incentive to place orders onto the Exchange, as our members report they will continue to be reluctant to place orders onto the Display Book if they know they will not be rewarded for taking the risk of displaying those orders.

“The Institute addressed this issue in our initial comment letter by recommending that the non-displayed orders placed under the broker agency interest file not be provided priority on the same level as fully displayed investor orders. We also recommended that, at the very least, brokers be required to display a portion of the orders in the agency interest file, in order to increase transparency on the Exchange and to enable investors to be better informed of how many shares are available at each price level.

“The amended proposal does not implement such a system. However, in expanding the ability of floor brokers to place orders in a broker agency interest file to the best bid and offer (and not only to price levels below the best bid and offer, as originally proposed), the NYSE is requiring brokers to display a minimum of 1,000 shares per broker6 and only the displayed agency interest at the best bid or offer would be entitled to parity with other displayed orders at the bid or offer price. Broker agency interest at the best bid or offer that is not displayed (‘reserve interest’) would yield to displayed interest in the best bid or offer. The Institute believes that such a system would reward market participants for displaying orders and may therefore provide incentive for investors to place orders on the Exchange. It remains unclear from the proposal, however, why the NYSE chose to pursue such a priority system solely at the best bid and offer and not at other levels of the book. While the Institute does not object to the Exchange providing floor brokers with the ability to represent their customers as they do today in the auction market (i.e., by working orders in the crowd), fundamental market fairness should dictate that displayed orders should be protected and provided priority in the execution process over ‘hidden’ orders. While parity may provide an incentive for crowd participation in the price discovery process, it does not provide such an incentive for investors. We therefore recommend that the Exchange provide execution priority on the same level as fully displayed investor orders only to the portion of those orders represented by floor brokers that are displayed. Those orders that are not displayed should yield to displayed interest, in the same manner as the hybrid market would operate at the best bid and offer”.

The Investment Company Institute (ICI) also expressed concerns over information transparency:

“In our initial comment letter on the hybrid market proposal, the Institute noted that under the hybrid market, certain types of information would be unavailable to investors. For example, much of the information that Specialists would be privy to when developing their proprietary algorithm would not be available to investors, e.g., the aggregate amount of broker agency interest at each price level.9 The Institute therefore recommended that the hybrid proposal be amended to make this information available to investors. The amended proposal, however, does not address this concern. We continue to believe that the availability of this information solely to Specialists could provide them with an unfair advantage over investors in interacting with orders on the Exchange and therefore reiterate the recommendation made in our prior comment letter”.

The SIA also had reservations regarding the Specialists and Floor Broker provisions:

“The filing does not provide sufficient information with respect to how NYSE floor members will participate in the hybrid market. The proposal provides for Specialist interest files and floor broker agency interest files that are not necessarily displayed unless a quotation in either happens to be the best bid or offer. This raises questions about the appropriateness of creating a hidden reserve book for those with a time and place advantage relative to the rest of the marketplace. Specifically, we have questions regarding the consistency with the Securities Exchange Act of 1934, particularly Section 11(a), of such time and place advantages in the context of a more automated market, and note that Regulation ATS does not allow for such informational advantages. According to the filing, floor brokers will have the ability to place within the Display Book system an agency interest file at varying prices at or outside the quote with respect to orders the broker is representing. It appears that floor brokers' orders outside the national best bid and offer will be undisclosed to the public. SIA believes further information on this new class of undisclosed orders called ‘floor broker agency interests’ is needed. For example, what is the effect of and public policy reasons for this new class of orders? This element of the proposal relating to floor brokers' orders may raise questions about priority and parity. It is unclear whether floor brokers' orders could take priority over the limit orders of public investors that may be priced at only one penny away from the floor brokers’ undisclosed interests. If a floor broker’s undisplayed order can, in fact, trade ahead of another investor's order priced at a penny better, then the floor broker, like all market participants, should be required to display at least a minimum amount (similar to the ability in Nasdaq to display 100 shares with hidden reserve), so that market participants are aware of the trading interest. The filing also needs to have more specificity regarding priority and parity when a floor broker has a hidden order at the same price as a displayed investor order. The NYSE proposal is silent on this point, but we would oppose any concept that was unfair to investors whose prices are displayed.

“Additionally, the filing lacks detail on the role of Specialists, including their ability to influence stock prices when trading for their own account. More information is needed on how priority and parity will work with respect to the Specialist file and whether orders in those files have any priority or precedence over incoming orders. Also, it is not clear how the Specialist would ‘systematically supplement the Exchange's published bid or offer.’ Specialists have the opportunity to supplement liquidity, and may be able to do so by devising algorithms based on data to which others do not have access. If this is the case, it would seem unfair to allow Specialists to use such proprietary algorithms that are based on prior trades and data not available to other market participants. Similar to the floor brokers’ undisclosed interests noted above, some hidden Specialist trading interests may be included in a sweep of the limit order book, and thereby affect investors' displayed orders. Accordingly, we believe the NYSE should provide more information regarding how the Specialist file will work”.

The Timber Hill LLC and Interactive Brokers LLC comment letter usefully pulls all the threads together:

“The proposed rules would create a hybrid market featuring elements of electronic trading and elements of open outcry trading. By increasing automatic execution, identifying in real time when NYSE quotes are automatically executable, and protecting electronically accessible quotes of away markets, among other things, the NYSE hybrid market will be consistent with the sound principles set forth in proposed Regulation NMS (‘Reg NMS’). As long as Reg NMS is approved as well, the hybrid market rules will facilitate competition and increased liquidity and transparency both on the NYSE and on other US equity markets.

“When the first iteration of the Exchange's hybrid market rules was published in August, we raised concerns that the proposed rules, and the Exchange's description of how those rules would operate, lacked sufficient specificity to allow Commission approval. With its detailed and thorough second amendment of the rules, we believe that the Exchange has addressed these concerns. With the creation of the hybrid market, the Exchange will go a very long way toward automating its operations and increasing the fairness and transparency of NYSE trading.

“Both the NYSE hybrid rules and proposed Reg NMS (which we also strongly support) will facilitate further automation of quoting and trading while at the same time allowing manual market processes to continue and to flourish where appropriate. The hybrid rules strike a good balance by fully automating most routine quotes and trades and yet allowing Specialists and floor brokers to supplement liquidity and provide price improvement through manual, auction market processes (for example using the interest files to facilitate single-price executions and to keep undisplayed volume in reserve at their discretion). Under proposed Reg NMS, in turn, undisplayed size and manual quotes will not be protected from trade throughs by other markets.

“The hybrid rules and Reg NMS thus strike a good balance in which no particular market structure (i.e., completely automated trading) is dictated by regulatory fiat, but neither will Specialists and exchanges continue to benefit by failing to automate their operations (as they benefit now under the outdated ITS trade through rule which protects manual market quotes and forces order flow to seek those quotes even though such quotes often are not truly firm).

“Indeed the two proposals approved together will provide an excellent structural framework going forward for US equity markets. Neither the hybrid rules nor Reg NMS seem to dictate winners and losers but will instead allow market forces to determine how orders for various types of market users (e.g., small investors, hedge funds, block traders, etc) will be handled and executed”.

Outlook for the Specialists – electronic shoot out in Last Chance saloon?

According to Bloomberg, the New York Stock Exchange Specialist firms collectively lost USD38m in 2004, their first annual loss since NYSE began tracking market maker profit in 1988.

The seven firms had an after-tax profit of USD3m in 2003. Their previous worst results were in 1990, when there were 45 Specialist firms and they collectively earned USD1.1m.

In spite of dramatic consolidation the businesses are not large by capital market standards.

For example LaBranche and Co LLC, ranked by NYSE as one of the most active firms earned revenues of USD245m in 2004.

The current Specialists and their ranking

Specialist firm	Total stocks	% stocks	% dollar volume
LaBranche & Co LLC	577	22.1	25.4
Spear Leeds & Kellogg Specialists (Owned by Goldman Sachs)	557	21.3	23.9
Fleet Specialists Inc (Now Banc of America Specialist)	434	16.7	19.7
Van der Moolen Specialists USA	380	14.6	11.7
Bear Wagner Specialists LLC	353	13.5	15.1
Performance Specialist Group LLC	179	6.9	1.8
SIG Specialists Inc	129	4.9	2.4
TOTAL	2,609	100	100

Source: NYSE October 2004

A key factor mentioned by LaBranche concerning declining revenues and profitability was the nine-year low in equity market volatility as evidenced by the CBOE’s Volatility Index, a key measure of market expectation of near-term volatility and investor sentiment. According to LaBranche, as volatility in markets diminishes the need for Specialists to employ capital to mitigate volatility decreases, which in turn reduces Specialists’ level of principal participation and revenues.

Five of the Specialist firms have also been affected by scandal. In March 2004 the SEC announced the settlement of a long running investigation into violation of Federal Securities Laws and NYSE rules in which the firms Bear Wagner Specialists, Fleet Specialist, LaBranche & Co, Spear, Leeds & Kellogg Specialists and Van der Moolen Specialists were required to pay more than USD240m in penalties and disgorgement.

In a joint investigation, the NYSE and SEC found that, between 1999 and 2003, the five firms, through particular transactions by certain of their registered Specialists, violated federal securities laws and Exchange rules by executing orders for their dealer accounts ahead of executable public customer or ‘agency’ orders.

NYSE has also been severely sanctioned over the affair and has been required to submit to outside monitoring for the first time in its 213-year history. The SEC will monitor the exchange as part of the NYSE’s USD20m settlement with regulators.

Also, at the time of writing SEC indictments of 15 named traders are pending, as are several civil suits.

Now let us look at the key roles of the Specialist and examine how they stand up in world of automated electronic trading.

The Specialist as Auctioneer – The first observation is that reducing the quite severe restrictions on the use of NYSE Direct+, coupled with the inherently liquid nature of NYSE-listed stocks, is likely to promote substantial growth in electronic trading through the Display Book. Just look at the growth in NYSE Direct+ volume with the restrictions in place:

NYSE Direct+ average daily trading volume

Year	Shares	Direct+ % of NYSE volume
2004	140,587,853	10.1
2003	84,050,691	6.2
2002	50,708,528	3.6
2001	22,595,251	1.9

Source: NYSE 2004

Given that a large proportion of orders flowing into the NYSE may be matched electronically in the medium term, the prospects for the Specialists as Auctioneer must be bleak. Even the roles of opening the market and resumption of trading after a halt are performed perfectly well in other markets without Specialist intervention using automated single price call auctions.

The Specialist as Agent or Broker – The ability to route market and limit orders electronically into the Display Book and to have assurances that they will be automatically executed in price/time priority with Trade Through protection will call into question the value provided by the Specialist in acting as an agent or broker and the justification for Specialists commissions. In this context it is worth noting that is common practice in most electronic markets to encourage customer limit orders by charging no commission on orders lodged in the public limit order book – the convention is the aggressor pays the commission, as the liquidity taker.

The Specialist as Catalyst – As a critical mass of electronic trading is reached coupled with inevitable demand for more transparency of the book the need for the Specialist to act as a trading catalyst will surely be surpassed.

The Specialist as a Principal or Dealer – It is in this area where the Special can add most value but only, it appears, in times of market volatility. The value added by the Specialists in reducing volatility effectively by trading against short term market trends is a generally accepted and is increasing cited in marketing material issued by NYSE and the firms themselves. For example a recent study by the US Office of Economic Analysis found that:

“On average, stocks experience a significant decline in intraday volatility upon moving from Nasdaq to the NYSE”.

But trading against short term trends, with the attendant risk of substantial inventory losses is hardly a basis on which to build a viable business, particularly as Specialist earnings appear to be sensitive to longer term volatility cycles.

A key issue for the Specialists going forward is whether they can make a viable business of trading in a principal capacity within the constraints imposed by the current NYSE rules in a new era of electronic trading?

It is likely that the balance of Specialist benefits and obligations will need to be reviewed as automation takes hold. Maybe the simpler market-making rules employed by other automated exchanges in London and continental Europe, who use principal dealers to supplement liquidity in their public limit order book, could serve as a model.

However, the Specialists are hardly in a good position to negotiate better terms. The recent scandal has made them no friends, and they stand to lose influence at the NYSE as it moves to a publicly-traded for-profit entity. Moreover, in making this move combined with the acquisition of Archipelago Holdings Inc with its simple public limit order book approach to trading, NYSE seems to have hedged itself against a world without Specialists. It also appears that automatic execution of orders through the Display Book could be accomplished without Specialist intervention, albeit with increased volatility and loss of continuity when there is an order imbalance.

However the Specialists seem to have been thrown a lifeline, namely the franchise to trade algorithmically via a two-way API into the Display Book on an order-by-order basis.

Already NYSE Rule 104 – Dealings by Specialists, contains the necessary enablements for algorithmic trading in Investment Company Units or Trust Issued Receipts:

“Specialists shall have the ability to establish an external quote application interface (‘Quote API’) which utilises proprietary algorithms that allow the Specialist, on behalf of the dealer account, to systematically update the Exchange published bid or offer within the Display Book system in Investment Company Units (as defined in paragraph 703.16 of the Listed Company Manual), or Trust Issued Receipts (as defined in Rule 1200).

Under the Hybrid Market Proposals this is extended as follows:

“Specialists shall have the ability to implement proprietary algorithms that allow them on behalf of the dealer account, to systematically supplement the Exchange published bid or offer, match bids and offers published by other market centres, and place within the Display Book system a Specialist interest file at varying prices outside the published Exchange quotation”.

All Specialist trading, whether manual or electronically generated by algorithms, will of course be in accordance with Exchange Rules, and there are numerous caveats and conditional statements in the drafting of the algorithmic trading rules.

Under the proposed new rules, algorithms may be designed to have access to public information as well as orders entering the system.

Algorithms may generate messages only in reaction to one order at a time and only as that order is entering the system. Algorithms will be required to identify, in the manner required by the Exchange, the specific order to which they are reacting. The fact that algorithms have generated a message in response to a particular order does not guarantee the Specialist interest will be able to interact with that order, nor does it give the Specialist interest priority in trading with that order. Specialist interest that does not trade with the order identified by the algorithms, for example, because the Specialist order did not arrive at the book in time, or the Specialist has to yield to the book, will be automatically cancelled.

Based on predetermined parameters, the algorithms may only (i) generate a bid (offer) that improves the Exchange best bid (offer) price or (ii) withdraw a previously made best bid (offer), provided the algorithmic decision to improve or withdraw a bid or offer is not based on a particular order entering the book; (iii) supplement the size of an existing best bid (offer); (iv) match better bids (offers) published by other market centres; (v) facilitate a single-priced execution at the Exchange best bid or offer, provided the entire order is filled; (vi) layer Specialist interest at prices outside the quote, enabling the Specialist, to the extent permitted by Exchange rules, to participate in or price improve a sweep; and (vii) provide meaningful price improvement to orders.

The algorithms will not be able to hit bids or take offers.

It remains to be seen if the Specialists can succeed in standing Canute-like against a sea of proprietary and quantitative traders whilst operating within the NYSE-imposed constraints. The new rules will play to the Specialists who have access to quantitative and proprietary trading skills, ultra-fast technology and plenty of risk capital. Clever dynamic hedging will be key in managing inventory risk. Specialists who are already active derivatives market makers can be expected to have an advantage.

In any event it is clearly time for the Specialists, in the best tradition, to break a leg!