On the SEC Probe of NYSE “Specialist” Firms: Time Free the Stock Market to Make it More Competitive

by | May 4, 2003

The SEC is investigating possible abuses by the “specialist” firms that match buyers and sellers on the floor of the New York Stock Exchange. The probe comes after revelations that the exchange itself had launched an investigation last year that is now reported to involve five of the seven specialist companies. One of those firms, […]

The SEC is investigating possible abuses by the “specialist” firms that match buyers and sellers on the floor of the New York Stock Exchange. The probe comes after revelations that the exchange itself had launched an investigation last year that is now reported to involve five of the seven specialist companies.

One of those firms, Fleet Specialist, last month suspended David Finnerty, who handles trades in the NYSE’s largest stock, General Electric. The Wall Street Journal disclosed Monday that Fleet had been fined $150,000.

The burgeoning scandal, which could prove as jolting to investors as previous ones involving Wall Street stock analysts and initial public offerings (IPOs), should actually come as no surprise. The anachronistic trading system at the NYSE, which has changed little since the exchange’s founding in 1792, has long been an accident waiting to happen.

At a time when high technology allows the NASDAQ, most foreign markets, and electronic communications networks, or ECNs, to trade stocks without human intervention, the NYSE has insisted on continuing to use the “open-outcry” auction system. Buy and sell orders for each of the 2,800 stocks listed on the exchange flow to a specific post on its famous floor at Broad and Wall Streets in New York. There, specialists complete transactions.

The problem is that the specialists play a dual role that is fraught with conflicts of interest.

On the one hand, they conduct auctions among floor brokers who represent buyers and sellers of the stock. But, on the other, the specialists buy and sell stocks for their own accounts – with a major advantage since their position makes them “privy to information that the guy in Milwaukee just doesn’t have,” in the words of Christopher Barrow, a Boston-based investment advisor quoted by the Journal.

In fact, one-fourth of all transactions on the floor of the NYSE involve specialists’ own capital.

The specialists are supposed to inject funds in order to smooth the trading process – a dubious measure in economic terms. But whatever the reason, the system gives specialists abundant opportunity to engage in a practice called “front-running,” or giving the best deals to themselves and inferior execution to their customers.

For example, Barrow, according to the Journal, says that three weeks ago, he tried to sell 10,000 shares for a client. When the bid from the floor of the NYSE came back $1 below the last trade, he rejected it. But, Barrow claims, a specialist jumped in front of him and crossed a trade at the price he was seeking.

“Everybody who does what I do feels like it’s basically a stacked deck down there,” said James Malles, head of U.S. equity trading at UBS Global Asset Management, quoted in the Journal, which broke the story of the investigation last week.

“There’s an inherent conflict. The specialists have to provide a fair and orderly market, but they can trade for their proprietary account. Those are clearly in conflict with each other.”

The real question is why the archaic system has lasted so long.

One reason is that the specialists are enormously powerful within the NYSE itself. The exchange became a non-profit corporation 30 years ago, with a 25-member board of directors. Representatives of three specialist firms – LaBranche & Co., Fleet Specialist and Bear Wagner Specialists – sit on the board. The CEO of Bear Stearns Cos., which has a minority interest in Bear Wagner, is also on the board, as is the CEO of the Goldman Sachs Group, Inc., which owns a fourth specialist, Spear, Leads & Kellogg.

Another is that the NYSE operates as an exclusive club, with limited competition. Nearly all the trades in the stock of the largest U.S. companies, including 28 of the 30 Dow Jones Industrial Average, must occur on the floor of the NYSE. Companies that want to leave the exchange and move, say, to the NASDAQ, face severe restrictions from Rule 500, an infamous regulation of the exchange that critics liken to the code of the Cosa Nostra or a “Roach Motel”: once you’re in, you can’t get out.

Earlier this year, the American Stock Exchange, a rival, complained to the SEC about rising NYSE fees. “The normal result of price competition is stymied because NYSE companies cannot freely exit NYSE as a result of the constraints imposed by Rule 500,” Amex said in its letter to regulators. “Rule 500 thereby confers effective monopoly power on NYSE, which is free to raise prices with impunity.”

In addition, the Securities and Exchange Commission has been slow to act on a request to give NASDAQ registration as an exchange. Among other things, that would let NASDAQ, now classified as a “market,” to raise more capital and become a more robust competitor to the NYSE.

The specialist scandal, Reuters reported “could mark another significant public disgrace for the world’s largest stock exchange.” In October 2002, Martha Stewart, CEO of Martha Stewart Living Omnimedia, resigned from the board just four months after joining it. She was under pressure from investigators examining her possible role in an insider-trading scandal involving another company, Imclone Systems. The investment bank of another director, Kenneth Langone, was charged by regulators with unlawful profit-sharing activities in connection with initial public offerings of stock.

Richard Grasso, the NYSE’s chairman and CEO, came under public criticism for serving on the board of Computer Associates International, whose accounting was subject to a criminal investigation. He also admitted that he had neglected to file timely statements for stock compensation from Computer Associates over five years. Grasso resigned from that board but continues to serve on the board of Home Depot, Inc., which Langone co-founded in 1978.

More recently, the NYSE was attacked by Eliot Spitzer, the New York attorney general, after it nominated Sanford Weill, CEO of Citigroup to its board as a “public” representative. Weill withdrew his name. A few days later, Todd Christie also withdrew as a board nominee after he suddenly resigned from his position as CEO of Spear, Leeds, the exchange’s second-largest specialist firm. Christie said the reasons were personal.

The embarrassments involving board members are minor, however, compared with the potential of the specialist scandal, which goes to the heart of the system that the NYSE has maintained in what amounts to a rear-guard action against the future.

While the trading floor provides an exciting venue for TV cameras and visiting dignitaries, it is strange anachronism in a modern age – and costly and inefficient for investors. Data reported to the SEC, for example, show that NASDAQ, which, like nearly all the world’s largest markets, uses electronic order-matching, on average executes trades faster than the NYSE, with tighter “spreads” – or differences between bid and asked prices.

If the scandal grows, there will undoubtedly be calls for stricter regulation of specialists. But that’s not the answer. First, the NYSE needs to be more forthcoming about its deficiencies. The exchange still does not warn investors when a listed company’s financial position no longer meets its standards. (The New York Times reported, however, that exchange officials said “they would begin to provide some warning, as the NASDAQ has long done.”) The fine imposed on Fleet last week was disclosed only recently by the press, and the exchange’s broader investigation into the specialists was revealed months after it began.

But more important than disclosure is competition. In a true competitive market, companies don’t last very long if they abuse the trust of customers. It’s time to apply competitive market discipline to the world’s largest stock market itself.

Ambassador Glassman has had a long career in media. He was host of three weekly public-affairs programs, editor-in-chief and co-owner of Roll Call, the congressional newspaper, and publisher of the Atlantic Monthly and the New Republic. For 11 years, he was both an investment and op-ed columnist for the Washington Post.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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