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September 28, 2006

Capital Rules Eased for NYSE Specialist Firms

By Gregory Bresiger

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  • Capital Rules Eased for NYSE Specialist Firms
  • Page 2

It's easier now for a Big Board specialist firm to get hitched.

That's because the New York Stock Exchange Group's specialist "marriage penalty" capital requirement was just eliminated under a rule change approved by the Securities and Exchange Commission.

Big Board capital requirement rules had stipulated that a specialist firm merged with another must continue to meet the collective capital requirements of each of the firms.

"These were not rational requirements," Grace Vogel, executive vice president of member firm regulation for the New York Stock Exchange, told Traders Magazine.

"A lot of excess capital was accumulating at the merged firms that far exceeded the amount they needed to manage their risks."

Lower capital requirements, trading executives say, will ease the strain on specialists' finances and would allow them to pay down debt or merge with smaller firms. Capital requirements include the minimum liquid assets a specialist firm is directed to have on hand to close out positions.

But these capital requirements have been hurting specialist firms, Vogel said. So NYSE officials, in changing Rules 104.21 and 123E(f)(i), have reduced specialist net liquid capital asset requirements by 38.8 percent.

The specialist net capital formula goes from one based on valuation of classes of allocated securities, including capital penalties for specialist mergers, to one based on specialist market share as measured by total dollar volume traded, combined with market stress and volatility risk analysis.

Specialists are now required to have $1 billion in net liquid assets or satisfy the requirements of Rule 104.21. The latter stipulates that a specialist firm meet a capital standard of $1 billion for each one-tenth of one percent of exchange transaction dollar volume in its specialty securities, plus $500,000 for each ETF.

A specialist must also have an exchange-approved value at risk (VaR) model. Value at risk computes the firm's market risk in general terms. VaR measures how much a firm could lose in a single day's trading, according to Rule 104.21.

Under the previous method of figuring the capital rules, all NYSE specialists collectively had been required to maintain $1.8 billion in capital. They generally have had some $2.3 billion on hand, according to Big Board officials.

The new rule, expected to go into effect gradually over the next four quarters, permits the capital requirement to drop to $1.1 billion for the specialist firms. But NYSE officials, in their filing wrote that "it is anticipated that they would maintain capital in excess of that requirement."

Critics of the easing of NYSE specialist capital requirements say it will lead to the undercapitalization of firms. What would happen, they asked, if there is another crash?

One or two NYSE specialist firms failed in the 1987 stock market crash, Vogel said. But those that did were acquired and their obligations were taken over by others, according to Vogel.

But lower capital requirements could cause problems for investors as NYSE specialists cope with a new hybrid market system and the next bear market, critics warn.