Big Board Specialists Under Siege
It was shortly before 1 P.M. on Oct. 21, when a floor broker from a large institutional firm walked up to Post No. 5 on the main trading floor of the New York Stock Exchange. His client wanted to buy 50,000 shares of medical-devices manufacturer Zimmer Holdings Inc. (ZMH ), which trades at the post and is red-hot, climbing more than 40% so far this year. Big investors have been snapping up Zimmer shares -- and in such situations, the job of the specialist in charge of trading the stock, Richard T. Barry of LaBranche & Co. (LAB ), is to step in when there aren't enough sellers out there. Or, in regulatory parlance, to use the firm's capital to make a "fair and orderly market" in Zimmer.
In this case, Barry was able to fill the order only by adding 15,000 shares from LaBranche's inventory to the 10,000 put up for sale by another floor broker. The trade, at $58.80 a share, was recorded at 13 seconds past 1 p.m. -- and it turned out to be one of the best buys, and worst sells, of the day in the stock. Zimmer closed at $58.94 -- which meant a $2,100 paper loss to LaBranche that day on the 15,000 shares Barry had used to fill the customer's order. "The specialist didn't know where the stock was heading. But he did his job, put up our capital" -- and provided liquidity that allowed a large order to be filled, says Michael LaBranche, chairman and chief executive of the largest of the seven NYSE specialist firms.
All in a day's work for a specialist? Not entirely. Their main job, right now, is survival. As the 211-year-old NYSE wrestles with life after disgraced CEO Richard A. Grasso, the specialist system is, in Street parlance, "in play." Specialists are not worried about interim Chairman John S. Reed, whose go-slow approach -- and pro-floor statements -- have reassured traders. More likely to undermine the specialists' franchise are potential regulatory changes designed to increase competition between the NYSE and other markets and trading systems. Regulators also want to address complaints from big institutional investors about specialist misconduct, such as trading ahead of customer orders (BW -- Oct. 27). The specialists' main competitors -- the electronic communications networks, or ECNs -- are anxious to exploit these troubles to boost their puny market share in NYSE stocks.
Fueling doubts about the system is an NYSE probe of alleged improper trading by LaBranche and four other specialist firms. All have declined to comment on the probe. But the amount they are expected to fork over -- believed to be about $150 million -- is chump change compared with the potential losses from increased competition, which, LaBranche concedes, may well eat into profits down the road. The Securities & Exchange Commission is clearly moving toward unleashing the free market onto the trading floor. Annette L. Nazareth, director of the SEC's Market Regulation Div., puts it this way: "We are creating an environment that doesn't choose winners or losers. The marketplace that most responds to investor needs will most likely prevail."
But don't count the specialists out just yet. The SEC isn't likely to do anything to radically alter -- and thereby damage -- the current floor-trading system. Any changes are likely to be measured, gradual. SEC Chairman William H. Donaldson told BusinessWeek he doesn't believe the specialist system is inherently flawed. "We have to address possible rule changes that open up, force it to be more competitive, but without deciding it should go out of business. The goal is to encourage the benefits of the auction market along with electronic trading markets."
POSITION OF POWER
Specialists have history on their side. They have been adept at adjusting to changes that had been widely expected to cut into their livelihood -- ranging from the end to fixed commissions in 1975 to decimalization. Critics are keenly aware of the fact that specialists and floor brokers, by their ownership of seats on the trading floor, are the actual owners of the NYSE -- a built-in obstacle to significant change. Says Junius W. Peake, a finance professor at the University of Northern Colorado and longtime NYSE critic: "I'm old enough to remember when you picked up the phone and got an operator. If the telephone operators ran the phone company, they'd still be saying, 'Hello, central."'
The specialists' rivals are anxious to nudge them toward extinction. Instinet Group Inc. (INET ), an alternative trading system 63%-owned by Reuters Group PLC (RTRSY ), launched in September an ad campaign for its institutional brokerage. Its ads needle the NYSE by boasting "unconflicted sales trading" free of "front-running" and "ethical shenanigans." Instinet also funded a Greenwich Associates study entitled "What Do Institutional Investors Want in a Securities Trading System?" The report, unsurprisingly, found two-thirds of large investors surveyed don't think NYSE specialists or NASDAQ market makers add value in trading large liquid stocks. "No one's asking for the NYSE to do away with the specialist system," says Instinet CEO Edward J. Nicoll. "What we want is the ability to have our quote published side by side with New York's and let customers choose where to send order flow with out artificial barriers."
That's easier said than done because of the SEC's "trade-through" rule, enacted in the 1970s, that requires orders for stock to be executed on the market with the best price. Critics say that it now works to confine trades to the NYSE floor when the prices are only slightly better, even for customers who prefer fast executions over marginally improved prices.
The rule will probably not be abandoned entirely. More likely, it will be tweaked to allow trades that deviate from the best price by 2 cents to go to other markets. But the specialist system is likely to cope with such a change. "They'll figure out a way to offer automatic execution for orders coming in up to a certain size," predicts an SEC official. "No way they'll sit out and lose 80% of their market share before they wake up."
Not that the specialists' competitors aren't going to try. Gerald D. Putnam, CEO of Chicago-based Archipelago Exchange, or ArcaEx, thinks his firm will be able to attract significant market share away from the NYSE with only a 2 cents-3 cents exemption from the rule. He bases this on a year-old 3 cents exemption on the exchange-traded fund that replicates the NASDAQ 100 index. As a result, electronic markets now dominate trading in the fund. On Sept. 22, ArcaEx had 22%, vs. the NYSE's 6%. "With just a 3 cents exemption, we pretty much kicked their butt," says Putnam. With a similar exception for listed stocks, "we will see the monopoly power of the NYSE diminished, and the value of an electronic marketplace come through." But the NYSE's rivals assert that the trade-through rule is routinely ignored when they offer better prices. ArcaEx says that even though it offered the best prices on General Electric Co. shares 43% of the time one recent week, it had only a little over 1% of the volume in GE trades. Overall, ArcaEx and Instinet each generate only about 2% of the average volume in NYSE-listed stocks.
Any possibility of increasing that still-tiny market share isn't likely to happen very quickly. Donaldson declines to say when changes in the trade-through rule are likely to take place. They may be several months away -- long enough for public attention to the issue to wane. And Donaldson is sensitive to the dangers of excessive tinkering with the specialist system. Says Donaldson: "There's a tremendous liquidity pool at the NYSE. As we address the trade-through rules, we would not want to destroy that liquidity. In calm times, the electronic way of doing business works very well. But when you get a market dip, the liquidity on the floor of the NYSE is important. I fear a structure that would lack this liquidity in stressful times."
SAGGING SEAT VALUES
To LaBranche, who happened to be at the post with a visitor when the Zimmer trade took place, trades such as that are proof that specialists providing liquidity to the market is not an abstract concept. It is the firm's business -- and lately it has been decreasingly profitable, to the extent that the LaBranche board voted on Oct. 20 to omit its quarterly dividend. The firm, whose shares have slumped 60% this year, was placed on negative credit watch by Standard & Poor's. And the value of NYSE seats is also on the wane; they're now trading at $1.35 million -- a 27% drop in one month. With specialists now a piñata, NYSE insiders are clearly jittery. Says LaBranche: "The only thing most people know about us is that they hate us."
Fortunately for specialists, a bad rap does not immediately translate into extinction. With Donaldson and Reed in favor of gradual change, critics such as Peake do not believe that the system itself will change significantly unless the SEC or Congress directly intervene, which isn't in the cards. For his part, LaBranche believes that specialist firms will adapt to whatever changes are imposed by improving their technology and providing customers with increased execution speed. It's an existential struggle -- and for the specialists, failure is not an option.
By Gary Weiss in New York, and Amy Borrus and Paula Dwyer in Washington