Commentary: Under The Gun At The Big Board

Why calls to replace the specialists go too far

For years, institutional investors have quietly complained that the New York Stock Exchange has been, well, cheating them. The exchange's floor specialists, who are charged with keeping an orderly market by matching buyers with sellers, have been making fat profits off of their orders, they claim. Specialists take advantage of rules that let them see orders ahead of others, then trade on that inside information even when their assistance is not needed. Moreover, they assert, exchange rules protect the specialists by blocking funds from sending orders to faster, less expensive electronic markets.

Serious charges, to be sure. And they fell mostly on deaf ears -- until now. The sudden departure of NYSE Chairman and CEO Richard A. Grasso -- and the reform effort by ex-Citigroup boss John S. Reed, his temporary successor -- have opened a big window for institutions. In early October, Fidelity Management & Research Co. President Abigail P. Johnson personally lobbied Reed and Securities & Exchange Commission officials to get rid of specialists and adopt electronic trading. On Oct. 14, Fidelity upped the ante publicly: In an interview with The Wall Street Journal, Scott DeSano, head of global equity trading, repeated the call to scrap the specialist system. AIG Chairman and CEO Maurice Greenberg, a former NYSE director, also recently called on the exchange to repair the specialist system -- or else end it altogether. "Grasso's ability to keep electronic trading away is what protected exchange members and kept seat prices high," says Harold S. Bradley, senior vice-president at fund company American Century Investment Management Inc. "That's why he was paid so much."

A chorus of electronic markets, such as privately owned Archipelago Holdings LLC's Archipelago Exchange and Instinet, majority-owned by Reuters Group PLC, agrees. They say NYSE rules artificially constrain their growth. The double-barreled attack by powerful institutions and upstart electronic networks could spell big trouble for the specialist system.

PROS AND CONS But regulators, exchanges, and institutions should be wary of unintended consequences. Some of the rules now under fire are the product of well-intentioned but ultimately misguided efforts to make stock trading fairer. Specialists perform a valuable service when they use their own capital to smooth out bumps between supply and demand. "There are periods of stress when we are glad to have human beings" helping buyers meet sellers, SEC Chairman William H. Donaldson told the Senate Banking Committee on Oct. 14.

The problem is that NYSE rules seem to let specialists play middleman even when they aren't adding value but merely taking money out of investors' pockets. The chief beef is over an alleged practice called penny-jumping. It occurs when specialists use their information edge to sense which way prices are moving, then get ahead of the pack by buying or selling shares for their own accounts. "The specialist sees my order and other orders on the book and figures 'this stock will do better, so let me get involved here,"' says DeSano.

An NYSE spokesman says specialists, in general, earn their keep by curbing volatility and making sure investors get the best available price, which they do 93% of the time. And program traders and floor brokers penny-jump far more than specialists do, an NYSE broker says, because it helps their mutual-fund customers.

There's truth on both sides. When a mutual-fund order is penny-jumped, whoever sells the shares to the specialist gets a better price than he would otherwise. But that's no comfort to the fund whose order didn't get executed.

How does it work? Say Mutual Fund A places a limit order to buy 10,000 IBM shares at $50. Mutual Fund B wants to unload 10,000 IBM shares at the current market quote. The specialist sees Fund A's buying interest and figures prices are rising. But rather than let Fund A buy from Fund B, he "penny jumps," offering Fund B $50.01 for its shares.

What's wrong with that? The specialist used Fund A's limit order as a market signal and accumulated a cache of IBM shares to sell to the next buyer, presumably for more than the $50.01 that he paid. If the specialist guessed wrong and prices fall, he can still sell his shares to Fund A since its limit order sits, unfilled, on the order book.

Meanwhile, Fund A, whose limit order provided crucial liquidity and set the market price, got burned: The specialist has forced it to chase shares in a rising market. The result: Funds are hesitant to show their hand via limit orders, thus making trading more cumbersome and costly.

The solution is more competition and greater transparency. First, the SEC and the NYSE must let electronic markets compete for more of the NYSE's order flow. One possibility is to liberalize the so-called trade-through rule. Adopted in the 1980s, this rule says that one exchange cannot ignore, or "trade through," a better price at another location. But institutions say that today it's mostly used to prevent orders from going to electronic rivals. The SEC should adopt a proposal circulating internally that would let stocks trade on electronic markets, but only at prices that vary by a few pennies from the NYSE's best price.

SPEED OVER PRICE That sounds bad, but institutions trading huge quantities say they prefer the speed of electronic matching over the chance of getting a slightly better price by waiting 30 seconds for the specialist to act. Funds say the exchange's "best price" can be illusory anyway. Floor prices often aren't available in the quantities institutions need or the quoted shares are no longer available by the time a fund's order arrives on the floor. And the NYSE could do a lot more to stymie penny-jumping by letting institutions trade large orders -- for more than 25,000 shares -- with each other without going through the specialists.

The NYSE also must become more transparent. While the exchange is moving in that direction, the specialist system still resembles a poker game in which one of the players can see everyone else's cards. Floor brokers, institutions, and retail customers should be able to see the specialist's order book at the same time.

The NYSE will fight these changes. But with Grasso gone, specialists must prove their value. Their free ride on investors' backs should come to an end.

By Paula Dwyer

With Faith Arner in Boston

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