Commentary: The Big Board Risks Losing the Big Trades

When the New York Stock Exchange on Apr. 22 denied media reports that it was investigating its specialists for massive trading improprieties, it seemed to pull off a masterful bit of image management. By taking the unusual step of commenting on a pending probe -- and saying the problem was less serious than the media maintained -- the NYSE sought to diffuse a source of increasing public embarrassment.

But it's a bit premature for NYSE Chairman Richard Grasso to pat himself on the back. The chicanery that the exchange says it is probing, in fact, involves irregularities on the exchange floor that are hardly trivial: specialists making illicit profits on two dozen of the mostly widely held stocks traded on the Big Board. And that revelation is likely to fuel mounting complaints by institutional investors that the specialists, whose job is to make a "fair and orderly" market in the stocks assigned to them, often abuse their positions at the expense of investors. One sign of discontent: In 2002, the NYSE floor's share of volume in its listed stocks fell to 81.9%, down from 84% in 2001, the lowest level in a decade. Gripes one trader for a large institution: "I would trade every order I have off the floor if I could. I'm tired of having the specialist use my order for his own personal [profit]."

The temptation for specialists to profiteer is immense. Unlike the NASDAQ and most overseas bourses, which use computer networks of competing market-makers, the NYSE relies on human beings engaging in auctions on the exchange floor. For years, the NYSE has been dogged by allegations that its specialists and floor brokers profit from their access to market-sensitive information. In 1998, 10 NYSE floor brokers were indicted for doing just that, and nine of them pleaded guilty. The NYSE, without admitting or denying the allegations, settled Securities & Exchange Commission charges that it failed to police its floor adequately.

The most serious allegation that has faced the NYSE in the past is front-running, in which floor brokers place orders for themselves knowing a large order is about to be executed, then profit from the resulting price move. In its Apr. 22 statement, the NYSE said it was looking into a different sort of wrongdoing: specialists taking tiny profits from trades they were supposed to execute without making a cent.

But to angry institutional investors, that may well be a distinction without a difference. The litany of complaints from pension-fund and mutual-fund managers centers on NYSE trading costs, which have soared some 50% since 1997, according to researcher Plexus Group. Investors blame skyrocketing costs on excessive volatility, illiquid markets -- and specialists using customer information for their own gain. Traders feel the NYSE is too protective of its specialists. Says Peter Jenkins, head of North American stock trading at Deutsche Bank Asset Management: "There are a lot of special interest groups [at the NYSE] lobbying for things to remain status quo."

As a result, institutions are looking for better ways of trading big blocks of stock without moving the price. More than half of the 100 largest U.S. institutions have already signed up to trade on Liquidnet, the Internet-based system launched in 2001. Add that to other off-exchange systems, including Archipelago Exchange, Instinet, and Posit, and it's clear the threat to the NYSE is real. Warns NASDAQ Chief Economist Mike Edleson: "There's a tidal wave of innovation and technology, and you can't stand in the way of that."

Technology can help keep the specialists out of hot water -- at least in theory. NYSE spokesman Robert Zito says a system could probably be designed to prevent the kind of conduct under investigation. But if the probe finds wrongdoing, says Zito, the penalties "will be harsh enough that I don't think anyone would ever do it again." Maybe. But the threat of penalties hasn't yet kept the exchange floor from being soiled by a dreary succession of scandals.

By Mara Der Hovanesian and David Henry

With Gary Weiss in New York and Mike McNamee in Washington

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