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January 1, 2004

Which Road Will the Big Board Take?

By Gregory Bresiger

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One Report Calls for SEC Intervention

The besieged New York Stock Exchange needs to make radical reforms. However, unless the regulators insist on a dramatic housecleaning, it is unlikely that anything more than superficial changes will be made in the NYSE specialist system and the supervision of its members.

These are some of the predictions of a new report from Celent Communications, a financial and consulting firm. The new leadership that follows temporary NYSE Chairman John Reed is only likely to make "incremental change," according to the report.

John Thain, the Goldman Sachs President and COO named as the Big Board's new CEO has, nevertheless, vowed to keep the NYSE the "most liquid" market even if that requires more electronic trading. Will that be enough?

"Unfortunately," Celent writes, "significant overhauls, such as those recommended in this report are unlikely to occur at the exchange unless the SEC intervenes."

The report, "The New York Stock Exchange: It's Time for a Change," comes at a delicate time for the NYSE, an institution which has been hurt by the forced resignation of former Chairman Dick Grasso. That followed a spate of bad press, including charges of unethical floor practices, such as "unnecessary interpositioning" by specialists. This reportedly cost investors $155 million.

"There is strong resistance to change at the NYSE," Jodi Burns, an analyst with Celent and the author of the report, told Traders Magazine. "The NYSE wants to maintain the status quo." The NYSE was unavailable for comment.

The report also comes atop of a recent survey conducted for Instinet by Greenwich Associates, which found that two thirds of buyside traders polled do not think NYSE specialists - nor indeed Nasdaq market makers - add value in trading large liquid stocks.

But what, in particular, is so troubling about the NYSE system? It defends its franchise, saying it offers investors the best prices on stock executions at least 94 percent of the time. The NYSE also contends that 44 percent of all orders receive price improvement.

Celent, which spares no mercy on the NYSE, describes a number of scenarios to counter the NYSE's case. It highlights the trade through rule. "For example, the NSE [National Stock Exchange] receives a market buy order and wants to match that order with its best sell limit order of $20.15," notes Celent. "But the NYSE is showing an ask of $20.10."

Celent writes that in this instance the NSE has two options: 1) It can execute the customer buy order at $20.10 (even though no NSE market maker is willing to sell at that price), or 2) Route the order to the NYSE specialist for execution at $20.10. Upon receiving that order, the NYSE specialist has up to 30 seconds to either execute the order or return the order unexecuted to the NSE. Incoming orders are not exposed to the auction market should the inside quote change while the order is en route, Celent notes.

ECNs are the most outspoken critics of the current trade through rule. This group believes the NYSE specialist is given a "free option" under the rule. "The specialist has 30 seconds to see if the markets will move in his favor," Celent notes.