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September 30, 2002

Jumping on the Bandwagon

By John A. Byrne

Are federal lawmakers indirectly responsible for impeding progress in the listed trading markets?

Are federal lawmakers indirectly responsible for minting millions of dollars in new revenues for New York Stock Exchange specialists while hurting customers who send them orders ? Is the regulation of our equity trading markets, therefore, a complete shambles? The answers, are yes, yes, and yes again, says a respected trading executive.

Before I introduce him, a wee bit of history is important. It was the Beltway regulators who ultimately mandated the introduction of stock trading in decimals. ("The whole world is doing it," was a familiar battlecry of the mandarins who write our laws.) So U.S. stock trading in pennies was introduced and it triggered the inevitable law of unintended consequences. This created a whole new class of trading professionals and trading strategies. The most obvious was the penny jumper on the listed markets. It cost the specialist only a penny to jump in front of large limit orders. "That's how the specialist is making all his money right now...penny jumping," said the trading executive Sanjiv Gupta, director of trading research and strategy at Bloomberg Tradebook. "The NYSE will say that technically someone is getting price improved but I don't buy that argument."

Ray Pellechia, a spokesman for the NYSE, said the exchange has seen no improper instances of specialists jumping ahead of orders. He notes that specialists only trade on a principal basis in some trades. But that does not exonerate the specialists, Gupta insists. "Say the specialist gets an order to buy 20,000 shares at $10. He can now step in front of that order and pay a seller of those shares $10.01. If the stock drops, he can sell the stock back to his customer at $10; if it moves up, he can flip it out. The damage is far more devastating to the $10 bid."

For this reason, says Gupta, more traders are now having their orders represented on the floor, instead of the specialist book. The $2 broker is busy. Admittedly, the trend could be good for Tradebook which is tripling the number of floor brokers it uses. Gupta makes no apologies. "We're saying," said this former academic, "that until things are improved, the broker on the floor presents a better way forward in the world of the Intermarket Trading System, in a world where the NYSE has regulatory protection." The Big Board reports that, since decimalization became effective, about seven percent of orders and 33 percent of NYSE volume have been executed through the crowd. An estimated 500 million shares daily are electronically delivered to the floor of the NYSE through so-called broker booth support. If you haven't figured it out, the lawmakers helped give birth to a renaissance in direct access trading. The upshot has had at least one wonderful effect. That human intermediary, the $2 broker, is back on the NYSE floor, stronger than ever before. The specialists, on the other hand, are reportedly penny jumping and having a grand old time.

John A. Byrne,