Date: April 5, 2004
Publication: Securities Industry News
By: Isabelle Clary Markets Editor

Not Quite Settled: Specialists wrap up SEC case, but their future remains up in the air

Five of the New York Stock Exchange specialist firms last week settled with the Securities and Exchange Commission for trading violations, but the agreement hardly lifts the cloud of uncertainty about the future of the auction system on the world's largest market.

Much of the outlook for the specialists depends on the SEC's Regulation NMS, a major reform that would let investors decide which criteria determine best execution as it relates to their trading strategies. The hotly debated issue is unlikely to be settled for months.

The SEC last week postponed its first Reg NMS hearing until April 21 in New York "to better accommodate the schedule of participants." The NYSE could not send a top executive to the hearing originally set for April 1 in Washington, due to a board meeting on that day.

Another important factor for the specialists' future involves NYSE CEO John Thain's plan to fully leverage Direct+'s auto-execution technology and create a hybrid market, something that is suffering some delay as well.

Not So Fast

New York filed in February a short proposal to lift time and size restrictions on Direct+, but the SEC sent it back because specialists could still "freeze" auto-execution in several instances.

Reg NMS defines "an automated order execution facility' as an order execution facility that provides for an immediate automated response to all incoming orders for up to the full size of its best bid and offer...without any restrictions on executions."

It does "exclude market centers that turn off their automatic execution systems or otherwise limit the ability to access their quotes or orders on an automated basis," which Direct+ does for 100-share orders or when the spread is wider than usual. Under the February proposal, the NYSE could not be regarded as a fully automated or "fast" market.

The "fast" classification is crucial for the NYSE because Reg NMS would allow auto-execution markets to bypass a floor's best quote, in an exemption to the trade-through rule. The trade-through or "best-price" protection forbids trading at a price inferior to the best quote displayed on an NMS market of any kind.

While lifting all trading restrictions on Direct+ may seem simple enough, the NYSE faces a significant technical hurdle: how to ensure that specialists can keep up with rapid trade updates on the order-matching facility.

An even bigger challenge comes from Reg NMS's second trade-through exemption. Investors could opt out of best-price protection on an order-by-order basis, meaning that all markets, fast and slow, could be traded through anyway.

This exemption has led a number of NYSE members to question whether the Direct+ upgrade is worth the effort, in particular before the trade-through reform-which the NYSE opposes-is even approved.

Further, it is unclear whether Direct+ can be a technology match for platforms built to trade at the speed of light. Under the opt-out exemption, it is easy to envision how the smartest algorithms could scan multiple venues to arbitrage highly liquid NYSE stocks among markets operating at a different pace.

Overall, such prospects hardly provide an incentive for NYSE members to push for a Direct+ upgrade that may offer no protection against rivals while creating competition to the floor within the NYSE's own walls.

"We are going to be traded through or we are going to be opted out," complained one source close to the specialists, who predicted that the new Direct+ filing would not be ready for weeks or even longer.

The Direct+ dilemma is also a test of Thain's leadership, as he must balance the needs of two major constituencies-the NYSE's members and customers.

"We are threatened by our competitors, who are primarily competing on the basis of speed, which I talked about as something we are addressing. We can also be threatened by not listening to our customers," Thain said in the current issue of NYSE Magazine.

"Consistent with the requests of many of these customers, one of our first moves is to expand access to automatic execution at the exchange," Thain reiterated, signaling no major change in his hybrid strategy.

Important market participants, such major state pension funds, have voiced their support for reform.

"We are stating our concern about the responsible investment of billions of dollars of public investments, particularly pension funds," Louisiana state representatives wrote in a joint letter to the SEC. "We are in favor of reforming the trade-through provisions... [that] are obsolete."

The Cost of Doing Business

Thain announced the hybrid plan in February, while the SEC investigation into the specialists' trading violations was still unfolding. Now that the settlement has been reached, Direct+ support on the floor seems to be waning.

"We are very pleased the settlement has been finalized. It gives the specialists an opportunity to focus on what they do best, which is to bring buyers and sellers together in the most liquid, fair, efficient market in the world," said David Humphreville, president of the specialists association at the NYSE.

But the settlement hardly spells the end of the specialists' problems, especially on the financial front. The firms-LaBranche & Co., Fleet Specialist, Van der Moolen Specialists USA, Spear, Leeds & Kellogg Specialists and Bear Wagner Specialists-face a slew of class-action suits, whose claims are now bolstered by the NYSE and SEC findings. "In a joint investigation, the NYSE and SEC found that, between 1999 and 2003, the five firms...violated federal securities laws and Exchange rules by executing orders for their dealer accounts ahead of executable public customer or agency orders," regulators said.

According to a source close to regulators, the specialists engaged in practices harmful to customers, because they regarded it as "the cost of doing business in a decimal world."

The latest financial results show a sharp decline in specialists' profitability in such a world, where regulations are strictly enforced.

In 2003, when the probes were ongoing, NYSE specialists reported a net profit of $3 million on revenue of $987 million, a far cry from net profits of $397 million on revenue of $1.64 billion the prior year.

Despite harsh attacks from critics, the auction system retains strong support.

"The trade-through rule is one of the building blocks of the system, a guarantee that all customers will be treated fairly by the intermediaries serving them. We can think of no compromise in the trade-through rule that wouldn't result in a serious weakening of the integrity of our markets," CEO Richard Rosenblatt and COO Joseph Gawronski of Rosenblatt Securities wrote to the SEC.

"To the extent NYSE technology and rules are felt inadequate to deal with the speed required by investors today-even after the latest NYSE proposals on Direct + are implemented-or somehow give the NYSE an unfair advantage, the SEC should require that technology and rules must be adopted to deal with that reality," they said.

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