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February 2, 2006

Will the Hybrid Fly? The Big Board has to please both the Buyside and the Floor

By Peter Chapman

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The buyside wants an ECN. The traders on the floor want an electronic replica of the floor. The New York Stock Exchange is trying to please both. Will the hybrid' fly? Will it pass muster with the Securities and Exchange Commission? And, if so, will the buyside use it?

It's been two years since the Big Board first filed its plans with the SEC to incorporate more automatic executions into its mostly manual trading environment. Since then, the exchange has filed seven amendments to the proposal (with another on the way) and acquired an electronic competitor. Contentious issues remain and SEC approval does not appear imminent.

"The plan is not in trouble," an NYSE official told Traders Magazine. "We expected we would have had full approval of hybrid by the end of last year, but because of all of the changes here and at the SEC that was not possible."

Indeed, the regulator recently gave the New York the go-ahead to phase in some of its new rules and technology on a pilot basis.

Dual Pressure

Driving hybrid are regulatory pressures and customer complaints. The buyside wants more automatic executions and so does the SEC. The SEC's new trade-through rule will go into effect this June, effectively forcing the Big Board to automate or risk having its quotes ignored.

Its response is the semi-manual, semi-electronic hybrid' marketplace. Trades can occur within the Big Board's computer systems or on its floor. The proposal is a compromise that tries to balance the demands of those on and off the floor.

Institutions will get more automatic executions, but perhaps not as many as with an ECN. Specialists and brokers will retain much control over the trading process, but will likely participate in fewer trades.

The New York's transformation is not revolutionary, but evolutionary. The Big Board already offers automatic executions via its Direct+ system. In operation since 2000, Direct+ handles 12 percent of total NYSE volume.

Direct+, though, only accepts orders of 1,099 shares or less and requires waits of 30 seconds between orders. The elimination of these restrictions is expected to lead to a surge in electronic trading. That could jeopardize the need for a trading floor.

Yet, while opening up Direct+ is a dramatic step, the Big Board is not going fully electronic. The combination of Direct+ and the specialist's display book will not function as an in-house ECN.

Two major design elements will tie the trading on the book to the trading on the floor, giving floor traders more control over Direct+ than they have today. The end result is a transformation of Direct+ from a mini-ECN into an extension of the floor.

First, and foremost, specialists and floor brokers are being given special privileges. They will be able to use special reserve files and order types, for instance, not permitted to outsiders.

Second, the exchange is keeping (but reworking) the circuit breaker that now shuts down Direct+ in the event a stock runs too far, too fast. Once tripped, orders fall into the hands of the specialist.