Investors have shed few tears over the demise of the specialist firms that handled trades on the NYSE floor. But that has started to change with this summer's market swoon. Decimalization and the rise of electronic trading have conspired to shrink the ranks of the middlemen who are known as specialists at the New York Stock Exchange and market makers in over-the-counter trading. Many people applauded the shift, believing these so-called buyers of last resort were more apt to take advantage of investors than to maintain "fair and orderly" markets. But the wild trading of recent weeks has some market players reconsidering that position -- and raising other questions about the recent explosion of electronic trading volumes. Take Wednesday's dramatic moves in Beazer Homes ( BZH). The Atlanta-based homebuilder's shares fell as much as 42% at one point on rumors the company was facing bankruptcy. Beazer denied the rumors at midday and its stock recovered some losses, though it still shed 18% on the day. (On Wednesday, Beazer shares jumped 14% to $13.04, aided by news
Citadel has increased its stake in the homebuilder.) The rumor-driven selling in Beazer -- as well as in Apple ( AAPL) earlier in the week -- in part reflects short-sellers' ability to generate outsized moves in individual stocks in a jittery market. But the volatility may be exacerbated by technological and structural changes in the market that has left a vacuum in the human specialists' wake.
"If the electronic trading alternative was not there, most likely, in this situation, a specialist would have seen an imbalance in sell orders hitting
Beazer's stock," says Joseph Saluzzi, co-head of equity trading at Themis Trading, an independent agency broker. He says the specialist "would have either had to step in and commit capital to take the other side of the trade or they would have halted the stock due to the imbalance." With demand for electronic trading soaring and the advent of Regulation NMS, which seeks to break down barriers between exchanges, "investors need to realize NYSE stocks trade essentially like Nasdaq stocks -- it's essentially one market," Saluzzi says. "All the program traders and shorts were smelling blood and they just crushed Beazer and the rest of sector. You have to wonder what a specialist would have done in the 'old days,' but why step in if there's no profit incentive?" At NYSE Euronext's ( NYX) analyst day in June, Duncan Neiderauer, president and co-CEO and head of U.S. cash markets, pledged to support rule changes "in places where I think the pendulum has swung too far." He was speaking of the balance of opportunities and risks for NYSE specialists, according to a transcript of the analyst day on the NYSE's Web site. On Thursday, an NYSE spokesman said there has been no public comment from the Securities and Exchange Commission on such issues. He declined to comment further on regulatory issues or Wednesday's trading in Beazer.
Ideally, a less restrictive regulatory framework would "free up the specialists so they can trade more profitability -- and trade more," says one industry observer, who requested anonymity. That, in turn, would encourage specialists to commit capital to prevent wild trading in shares of individual stocks in times of stress, not to mention the broader market. But, again, critics say the specialists have rarely, if ever, played the hero -- stepping into the breach of a major market upheaval to stem declines or even just restore rationality in fast-moving markets. Moreover, even if specialists were to receive regulatory relief, the reality of modern market structure would mitigate their influence. The reality is, so much trading happens away from the NYSE's hallowed floor that specialists could never have the kind of control and influence as they once did. On Wednesday, for example, 2.3 billion shares of the 5.6 billion shares of NYSE-listed stocks that traded were handled on Nasdaq, according to the firm. Meanwhile, Nasdaq's matched market share in NYSE-listed securities reached a record 20%. Matched market share refers to trades executed on Nasdaq's systems, excluding those routed to other market centers, including NYSE Arca, BATS Trading, LiquidNet and others. More electronic trades and the fragmentation of order execution have resulted in faster execution and lower trading costs for investors. But "fast, cheap and out of control" may be an apt description of the current environment, as reflected in Beazer's trading this week as well as the
canceled trades in Wyeth ( WYE) and prolonged halt in shares of AT&T ( T) and Jefferies ( JEF) on June 28 .
The challenge of integrating the NYSE's historic human-based auction system with computer driven trading on various platforms was on display again Thursday in shares of Comfort Systems USA ( FIX). Late Wednesday, Comfort Systems reported much stronger-than-expected second-quarter results. Faced with an imbalance of buy orders, the NYSE delayed the open of Thursday's trading in the manufacturer of heating and air conditioning equipment by 17 minutes. But trades occurred in electronic venues during that delay. Nasdaq was later forced to cancel trades covering 14,600 shares of Comfort USA -- including some that were executed, curiously enough, at a penny per share. Shares otherwise traded between $12.14 and $18.30 that day before closing up $1.84 at $14.80. A Nasdaq spokeswoman declined to comment. As with the Wyeth case in late June, the NYSE can't truly claim this episode as a victory for man over machines. The exchange's own ECN, NYSE Arca, also had to cancel trades covering 600 shares of Comfort Systems for a penny. The penny trades were likely "stub quotes," bids made far outside the normal price range for a stock. Market makers use stub quotes to technically comply with requirements they create two-sided markets, but the size of the spreads are not regulated. Last summer at a Securities Traders Association Conference, NASD Vice President Tom Gira expressed concern stub quotes were a sign "that people are registering as market makers just to get the exemption" from rules prohibiting shorting stocks on a down tick, according to the Web site of Traders' Magazine
Of course, the "plus tick test," which dictated that investors could only short stocks on an uptick, was removed last month -- so it's unclear why the practice of using stub quotes continues. Perhaps it's a sign that bad habits are hard to break in a marketplace seemingly determined to do as much as possible to undermine investors' confidence.