Specialist Scandal Raises Stakes for NYSE Reform
For a long time after the Nasdaq Stock Market was created in 1971, many big investors claimed that the electronic trading system was rigged to benefit Wall Street brokerages at investors’ expense.
But market regulators mostly just winked and nodded at that contention. It finally took a Justice Department investigation of alleged brokerage collusion in the mid-1990s to force Nasdaq to begin cleaning up its act.
Those memories now are echoing in the canyons of lower Manhattan.
Already facing a deep crisis of confidence over the massive pay package given its now deposed chairman, Richard Grasso, the New York Stock Exchange last week announced that it planned to fine and punish five of its seven “specialist” firms -- the broker units that are the heart of the 211-year-old exchange’s trading system.
The NYSE said an internal investigation of market activity from 2000 through 2002 turned up a pattern of abuse involving the specialists stepping ahead of investors who wanted to buy or sell shares. Instead of acting as a facilitator, matching a buyer with a seller, the specialists in some cases tried to profit by getting between the investors, buying from one and selling to the other.
The practice was, in the NYSE’s words, “to the disadvantage of the customers.” Some investors either paid too much or received too little in their transactions, compared with if they had simply been able to trade with one another.
On Wall Street, they like to say that the client comes first. The torrent of financial scandals over the last few years showed that that often is a bad joke.
But it’s one thing for a retail broker to overcharge a few hundred clients for mutual fund shares. It’s quite another if investors worldwide begin to think that the premier U.S. capital market is a con game.
Coupled with the Grasso debacle and the likely resignation of most of the exchange’s directors once interim Chairman John S. Reed launches his overhaul of the market’s governance procedures, the specialist investigation dramatically raises the stakes for the NYSE as it seeks to chart its future.
For decades, the exchange has successfully fended off criticism that its specialist-based trading system was an anachronism in the computer age. Did we really need human beings to oversee stock transactions on a trading floor occupying some of Manhattan’s (and the world’s) most expensive real estate? Why not just let computers match buyers and sellers automatically, without a middleman taking a piece of the action?
The Nasdaq dealer scandal in the mid-1990s helped the NYSE make its case that the specialist system -- human oversight of trading on a well-lighted floor always in the eye of CNBC cameras -- was fairer for investors.
Now, the exchange’s allegations about its specialists’ conduct are the equivalent of loading the cannons for its enemies. And those enemies include not only Nasdaq but also the host of other all-electronic markets that have sprung up as a result of the market reforms forced on Nasdaq starting in 1997.
On the same day last week that the NYSE put its specialists on notice that they would face “substantial” fines for their abuses, a House Financial Services Committee panel was holding a hearing on the structure of U.S. capital markets.
One of the people called to testify was Jerry Putnam, chief executive of the Chicago-based Archipelago Exchange. Putnam founded Archipelago in 1997 as an “electronic communication network,” or ECN, to take advantage of the government’s directives opening Nasdaq stock trading to significant new competition.
Since then, Archipelago has grown to become a major Nasdaq competitor. Archipelago says it handles 28% of trading in over-the-counter stocks, and is the largest trader of the very popular QQQ, a fund that mimics the Nasdaq 100 index of that market’s biggest stocks.
ECNs such as Archipelago automatically match stock buyers and sellers based on the prices they indicate they’ll accept. There is no specialist or dealer to get in the way -- or to help, for that matter.
The rise of ECNs has taken a huge bite out of Nasdaq’s share of trading in its own stocks, to the point where Nasdaq’s share now is a minority rather than a majority.
Archipelago also has tried to take on the NYSE. But the success of ECNs in attracting trades in NYSE-listed shares has been limited. The exchange still controls more than 80% of trading in its own shares, even as mergers have reduced the number of NYSE specialist firms to seven from 40 a decade ago.
Putnam and other NYSE rivals assert that the exchange has made itself into a fortress, and that its trading franchise has been preserved not by virtue of good service but by regulations and market mechanisms that keep competitors outside the fortress walls, at investors’ expense.
The NYSE, Putnam told Congress, “evidences all the lethargic and inefficient symptoms of anti-competitive and monopolistic pathology.”
The exchange has consistently rejected those allegations.
At a news conference Thursday, NYSE Co-President Catherine R. Kinney said, “despite some of the frailties that we’ve uncovered [the NYSE] is the best market model for investors.”
The job of the specialist, Kinney said, is to bring buyers and sellers together at the best possible price. About 70% of the time investors on the NYSE trade directly with each other, with the specialist merely overseeing the trade. The rest of the time the specialist is either buying or selling, which is supposed to happen in the context of maintaining an orderly market (i.e., limiting volatility in share prices).
The exchange’s great advantage over other markets is that so many buy and sell orders are there in one place. That’s “liquidity,” and it is key to allowing market forces to determine the proper price for a security at any given moment.
What’s more, “Liquidity begets liquidity,” analysts at Merrill Lynch & Co. wrote in a recent report on U.S. market structure. “Traders go where the order flow is, because this is generally where they can find the best price.”
No one disagrees that the NYSE is a highly liquid market. But critics say that’s so because of federal rules that unfairly benefit the exchange, at the potential expense of investors.
Most major U.S. stock markets are linked via the electronic Intermarket Trading System. The system is governed by the so-called trade-through rule, which requires that an investor’s order for a stock be sent to whichever market is quoting the best price at that moment.
With NYSE stocks, “94% of the time the New York Stock Exchange is the best quote,” Kinney said.
Critics say that though that may be true, the price advantage can be a function of a savvy specialist improving the market price by a penny a share in order to do a trade, while the investor sacrifices speed in getting the trade done or can trade only a minimal number of shares.
The issue has troubled the mutual fund industry for years, said Ari Burstein, associate general counsel at the Investment Company Institute, the funds’ chief trade group.
“Our members have said they would forgo a penny price improvement for the opportunity to automatically execute their orders” directly with other investors, Burstein said.
The Merrill Lynch report takes the NYSE to task on the issue of speed in order execution. For trades of 2,000 to 4,999 shares, it takes the NYSE 19.1 seconds to complete a transaction, compared with 14.6 seconds for Nasdaq, the report said.
In a fast-moving market, a few seconds can mean a significant difference in prices to mutual funds and other institutional investors trading loads of shares.
Archipelago’s Putnam pleaded with Congress to amend the trade-through rule. Changing the rule would “lower competitive barriers and introduce authentic competitors to the NYSE marketplace,” he said.
A slower pace of trading helps specialists in other ways, NYSE critics say. Specialists may gain more information about the market and how stocks are moving, which can help keep them on the right side of trades.
Many institutional investors have long worried about “information leakage” as their large orders are routed to the exchange and the specialist, who is surrounded by traders who buy and sell for their own accounts.
Suspicions about information leakage may just deepen in the wake of the exchange’s allegations that specialists stepped in to profit when there was no reason for them to act as middlemen.
The NYSE’s Kinney didn’t try to understate the severity of the specialists’ alleged abuses, but she also said the trades in question amounted to about 2 billion shares over a three-year period. That is equivalent to about one day’s NYSE volume.
Reed, who testified at the same House hearing as Putnam last week, said he saw no reason to believe that there’s anything inherently wrong with the NYSE’s market structure.
But even before the trading investigation announcement on Thursday, the specialist system came under blistering attack by Fidelity Investments’ head stock trader in a press interview early in the week.
That followed an opinion piece in the Financial Times by Maurice Greenberg, the CEO of insurance giant American International Group Inc. (an NYSE-listed stock), who said that NYSE trading must be reformed “or we must find an alternative system that will operate in the best interests of shareholders in the 21st century.”
The specialist firms themselves were saying little last week, other than that they were awaiting more information as to the specific trading charges.
Yet the action in shares of one of the five firms, LaBranche & Co., suggested that the firms’ own investors are worried about what the future holds. LaBranche stock fell 17.6% for the week and is down 58% this year.
The specialist business has been a very profitable one over the years, even through the recent bear market. To critics, that confirms an innate conflict.
“If the specialists are making money, how can they be adding to market efficiency?” asked John Wheeler, head of stock trading at the American Century mutual funds in Kansas City, Mo. “You can’t have them both.”
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Tom Petruno can be reached at tom.petruno@latimes.com.
