New York Stock Exchange
interim Chairman John Reed has thrown cold water on those hoping to burn down the specialists' castle.
Reed told reporters Tuesday that the Big Board's
specialist system of trading generates significant value" to investors and that U.S. capital markets could become "dangerously fragile,
even brittle," if not for the NYSE.
He also cited benefits of a "tight coupling" between the exchange's regulatory and business operations, arguing that there is "no need" to split them. (Later Wednesday, Reed is expected to formally reveal recommendations for a restructuring of the exchange.)
The chairman's comments came at a conference in Orlando, Fla., hosted by the Association for Financial Professionals, and amid a very heated atmosphere following news of a
Securities and Exchange Commission
finding that improper trading by NYSE specialists cost investors $155 million in the past three years.
Revelations of the SEC's findings, as reported in
The Wall Street Journal
on Monday, heightened calls in some circles for a dismantling of the human-based specialist system. At the very least, the SEC report generated greater support for a separation of the NYSE's regulatory and business operations, including backing from SEC Chairman William Donaldson.
Reed's comments may sound like a victory for the status quo. But even some of the exchange's most steadfast critics concede that "ditch
ing the specialist system cold would create unnecessary havoc," as
contributor, and NYSE critic, Jeffrey Linderman recently opined.
On balance, many experts believe the problem isn't the specialist system itself. Rather, they say there's need for greater regulatory enforcement -- most believe the NYSE is better equipped to deal with the peculiarities than an outside body -- and some relatively minor tweaks to the system. Such alterations may help eliminate the abuses by specialists and investors' perceptions that they are getting a raw deal.
Among those advocating change is Sam Lek, CEO of NYSE member firm Lek Securities. Although Lek is an ardent proponent of electronic trading -- his firm is known for its electronic order execution system, ROX -- his recommendations are unlikely to please those who believe the specialists have outlived their usefulness.
"I wouldn't support a monolithic central marketplace
that was entirely electronic," Lek said in a recent interview. "The investing public is served by having a multitude of different sources of liquidity, including the NYSE system with its open outcry market."
Citing years of complaints from customers, Lek has long been calling for change in the specialist system, but not its abolition. "Yes, there is specialist abuse, but that doesn't mean all specialists always break all the rules," he said. "There's a need for closer monitoring, but I really think the whole discussion of
shuttering the system itself is not appropriate."
Isn't That Special?
To address problems with the current system, Lek offered the following recommendations, many of which he described in the
June 2003 edition of
Stretch Those Pennies
: To eliminate the practice of specialists besting the best bid or offer for a stock by a mere penny, Lek recommends that price improvement must be "at least 3 cents or half the spread
between the bid and offer prices, whichever is less." Such a rule "would strike a reasonable balance between price improvement and shutting people out," he said. It would also address a major complaint of the electronic communication networks (ECNs), which claim the NYSE's "trade-through rule" allows specialists to capture orders and inhibit electronic competition by besting the highest advertised price by a penny, as detailed
Tale of the Tape
: To avoid suspicions that specialists have front-run customer orders (or the actual practice), Lek recommended that if the time stamp on a customer order is prior to the print on the tape, the customer order takes priority. "No exceptions," Lek wrote in
. "No nonsense like 'the trade already took place, but just hasn't printed yet.' It's got to be 'first come, first serve,' and the time stamps on the order and the tape should determine who was first."
Similarly, Lek recommends using the tape as an "unimpeachable witness" for issues such as cancellation of orders and assuring specialists adhere to the SEC's "firm quote" rule. (Specialists are supposed to offer stock from their own accounts when an acceptable offer from a public seller is unavailable; they rarely do so, unless it's a sure thing.)
Other changes he recommended include publishing all "on the close" orders, more aggressive enforcement of rules that dictate commissions be negotiated, and that those rates should be made public.
Hating the Players, Not the Game
As with others, Lek argued the recent NYSE investigation of the specialists and the SEC report on the subject show the oversight is working, "even if it took a little bit to get going."
His main point is that transgressions by individuals speak to issues of personal conduct, "not the system" itself.
Many investors, having been fleeced by mutual fund houses and other fiduciaries, will no doubt disagree.
"Everyone who ever bought or sold 100 shares of
feels they've been robbed," said one former specialist, now working in academia.
The source, who requested anonymity, expressed chagrin and disgust that "these guys with those franchises could be that stupid."
The firms being investigated --
LaBranche & Co.
Fleet Specialist unit, BearWagner Specialists,
Spear, Leeds & Kellogg unit, and
Van der Moolen
-- are expected to agree to pay $100 million to $150 million in order to settle charges of wrongdoing, something many investors will perceive as yet another "slap on the wrist" for the wrongdoers.
But aside from advocating greater regulator scrutiny and (much) stricter penalties than those being discussed -- "these guys should be taken out and shot for compromising the institution," he said -- the source defended the NYSE and its human-based system.
"I'm an unreconstructed fan of the auction as a means of price discovery and finding liquidity," he said. "But for the first time, I'm concerned about the institution. It'll survive, but I think it will be diluted by the politicians."
As of Tuesday, John Reed seemed to plant a stake in the ground between the politicians and the exchange's modus operandi. He'll have to walk a very fine line to create a resolution that will satisfy all parties, and reaffirm the public's shaken faith in the Big Board.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.