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December 6, 2006

The SEC Approves New Specialists' Obligations

By Gregory Bresiger

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  • The SEC Approves New Specialists' Obligations

The negative obligation of New York Stock Exchange specialists under the exchange's Rule 104(a) has been reinterpreted for their benefit. Specialists now have more freedom to trade for their own accounts.

This is because the Securities and Exchange Commission, reviewing an NYSE hybrid market pilot package of changes, recently approved the new interpretation on an accelerated basis.

The Rule 104 reinterpretation allows specialists to make so-called destabilizing trades. They are now able to trade along with pricing trends, and not just against them. It is "appropriate to reinterpret the negative obligation away from an emphasis on trade-by-trade necessity," the SEC wrote in approving the rule change.

But critics charged the change was rushed through without a comprehensive regulatory review. This amounts to a rescinding, not a revision, of the negative obligation rule, they say. They add that the latest order is just a part of an NYSE regulatory policy in which the interests of institutional investor's are sacrificed in favor of those of specialists.

Previously under Rule 104, specialists were allowed to trade for their own accounts if they were trying to stop a falling market. In that case, they bought stocks for themselves to stabilize prices. The old Rule 104 interpretation that has been jettisoned also required them to obtain the exchange's permission to buy on upticks or sell on downticks.

The SEC approval, along with other hybrid market changes, came through the delegated authority of its Division of Market Regulation. That means the SEC staff, not the commissioners, approved these changes. The SEC declined comment on the reinterpretation.

Negative obligation under NYSE Rule 104(a), a rule that goes back to the Exchange Act of 1934, had required that each trade by the specialist for its dealer account meet a test of reasonable necessity. But the development of the national market system over the past few years obviated that test, NYSE officials told the regulators.

Indeed, John Thain, NYSE chief executive officer, has been saying for months that Rule 104 should be reinterpreted.

This break now gives specialists more power to take orders away from institutional traders. NYSE officials, in their filings, justified the elimination of the old interpretation. They argued that Congress, some 30 years ago in amending the Exchange Act, allowed for the possibility that the negative obligation could be changed by the SEC. That's provided that competition among market makers, specialists and other liquidity providers increased in the future. The SEC apparently believes the future is now.

"The institutionalization of the market, increased competition, and increased application of computer and communication technology has significantly decreased the time-and-place advantages of specialists," the SEC wrote.

Citing new services like NYSE's OpenBook, the SEC also wrote that there is now greater transparency at the exchange, giving "all market participants, both on and off the Floor, a greater ability to react to market changes."

An NYSE spokesman, responding to criticism of the new interpretation, said "even those who have opposed these hybrid market changes would have to admit there are many more competitors for specialists today than there were just a few years ago."

The SEC agreed. It cited the presence of upstairs liquidity providers, multiple OTC dealers, crossing networks and alternative trading systems.