Trading of NYSE ‘Specialists’ Scrutinized
Just as Wall Street was ready to close the books on a spate of image-tarnishing scandals, the New York Stock Exchange revealed Thursday that it was investigating possible wrongdoing at several major stock-trading firms.
The probe appears to center on whether so-called specialist firms, which act as middlemen between buyers and sellers of stock, took advantage of customers by “front-running” their orders. Typically in such situations, an investor attempts to buy stock at a certain price, but the firm jumps ahead to buy the shares for its own account and then resells them to the customer at a higher price.
One firm under scrutiny, FleetBoston Financial Corp., said it had suspended a trader as part of its internal investigation into possible improper activity.
The NYSE launched its investigation of the specialist firms this year, according to sources familiar with the matter. It is unclear how advanced the probe is or whether it has turned up any evidence of wrongdoing.
However, the investigation raises questions about the basic fairness of NYSE trading, and renews lingering doubts among small investors about the trustworthiness of Wall Street.
“This is a very serious issue,” if improper trading is proved, said Wayne Wagner, chief executive of Plexus Group, a Los Angeles-based trading consultant.
In that case, “it would not only take into question the integrity of the market structure, but it would once again test public confidence,” NYSE Chairman Richard Grasso said Thursday. Grasso said the NYSE would expel from the industry anyone who is proven to have broken trading rules.
The NYSE would not reveal details of its investigation, which it is conducting in its role as one of Wall Street’s regulatory watchdogs. Grasso said the Securities and Exchange Commission was notified of the probe.
News of the investigation, first reported by the Wall Street Journal, comes as major brokerage firms are expected shortly to finalize a $1.4-billion legal settlement with securities regulators over the conduct of stock analysts. Other high-profile probes have centered on initial public stock offerings and Wall Street’s dealings with Enron Corp.
The investigation also follows other recent flaps that have reflected badly on the NYSE.
Last month, the exchange drew heavy criticism for nominating Sanford I. Weill, chief executive of Citigroup Inc., to be a member of its board representing individual investors, even though his firm is set to pay a huge fine in the analyst settlement. This week, the firm of an NYSE board member was accused by regulators of IPO improprieties.
The missteps “certainly indicate the NYSE itself has a very severe credibility issue to address,” said Benn Steil, a market expert at the Council on Foreign Relations in New York.
Specialists, who work at circular trading posts on the NYSE floor, are the dealers responsible for “making markets” in the stocks of the 2,700 companies listed on the Big Board. Their job is to keep the trading fair and orderly in the stocks assigned to them as orders flow in via computer or through face-to-face bidding on the exchange floor.
The seven specialist firms are required to maintain enough capital to enable them to step in and buy a stock when a seller has trouble finding a buyer, or to sell shares out of their own inventory when a buyer can’t find a seller.
Because all orders flow through them, the specialists have better information about buying and selling interest -- and thus pricing of stocks -- than others on the floor. But they are prohibited by NYSE rules from taking unfair advantage of this knowledge.
Some critics say specialists have abused their roles and used their insight into daily trading patterns to profit at their customers’ expense.
Specialists were profitable in the late 1990s, but earnings have cratered in the bear market.
“They’re under a lot of pressure to produce profits,” said John Wheeler, head of equity trading at American Century mutual-fund group.
Profitability also has been hurt by the NYSE’s 2001 switch to pricing stocks in decimals. Until then, stocks traded in increments of eighths and sixteenths, which reformers said was inefficient and confusing to the public. One effect of decimalization was to shrink the markup that dealers made on trades.
In some ways, decimalization also made it easier for specialists to front run their customers, some experts say.
Previously, a trader had to pay at least an extra 6.25 cents a share to buy stock ahead of another investor. Now, they must pony up only an extra penny per share.
The NYSE probe may have been prompted by complaints from mutual funds and other large investors, experts said. Those players may have accepted questionable specialist trades while notching big gains in the 1990s, but now must watch their trading costs very carefully.
One area that the NYSE might be scrutinizing is the “SuperDot” system that electronically funnels buy and sell orders to the specialists’ posts. More than three-quarters of all NYSE orders arrive this way, although very large orders are typically handled the old-fashioned way: phoned in to floor brokers who then physically bring the orders to the specialists’ posts.
Fleet said it is cooperating with the NYSE probe. It also said it has placed trader David Finnerty on administrative leave. Finnerty had handled trading in the stock of General Electric Co., according to a person familiar with the matter.
Michael LaBranche, chief executive of LaBranche & Co., the biggest specialist firm, said “we always put the interests of our customers first.”
