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December 6, 2006

The SEC Approves New Specialists' Obligations

By Gregory Bresiger

Under the Securities Act of 1934 and various NYSE rules, specialists in the traditional auction market acted as both a broker and a dealer. Generally they have had two primary duties. They had to perform their negative obligations of obtaining the best price for the investor. And they had an affirmative obligation to offset imbalances in the supply and demand of a stock. But, in an increasingly electronic trading world, specialists, along with floor brokers, could find themselves an endangered species. Some market observers predict the end of the floor.

Therefore, the NYSE's reinterpretation of Rule 104 may be a matter of survival. Some NYSE officials privately say this new interpretation will provide a revenue boon for specialists. Recently, they have been reporting poor numbers as the advent of electronic trading continues to chip away at their franchise.

Yet the reinterpretation is part of a series of moves by the NYSE that critics claim constitutes a giveaway to the specialist at the expense of the public investor. NYSE critics also object that the SEC commissioners did not offer serious consideration of the Rule 104 change and other hybrid market changes.

"I cannot believe the Commission has not held meetings in public session to seek input on the NYSE's multiple rule change proposals," Junius Peake, an academic, a former trading executive and a regulator, wrote in an e-mail to SEC Chairman Christopher Cox.

He argued that the SEC had not thoroughly reviewed the "most important change in market structure" since the passage of the Exchange Act in 1934: the NYSE's transformation to an electronic exchange.

"These proposed rule changes have not yet been approved by the Commission," Peake wrote. "In addition, Mr. Chairman, most (if not all) of the Commission Releases concerning the NYSE's hybrid market proposal have been approved by the Division of Market Regulation, not by the Commission itself."

"We cannot address this point," said a spokesman for the NYSE. "This is an issue for the commission and not for us to consider." An SEC spokesman responded, "We let these orders speak for themselves," when asked about the commission's rationale and why the commissioners did not vote on the measure.

George Rutherfurd, a consultant to institutional trading groups and a NYSE hybrid market gadfly, asserted that the NYSE is distorting the will of Congress through its new view of Rule 104. He also says the new interpretation is part of a scheme to rig the exchange rules in favor of specialists. In a comment letter to the SEC and in an e-mail to Traders Magazine, he notes that only specialists will be licensed by the exchange with unique algorithmic trading tools under the hybrid market plan.

"The stabilisation proposal largely lifts tick-based restrictions on the exercise of that exclusive license." Rutherfurd said. The plan is "highly problematic and anti-competitive," he said. In his comments to the SEC, he pointed out that the Rule 104 reinterpretation amounted to a revocation of the rule. He added that the SEC is replacing the rule "with a practice or pattern test that is clearly an open sesame for direct specialist competition with public orders."

A buyside trading executive who didn't want to be quoted by name said the negative obligations change "was very worrisome."

"They are going to be privileged intermediaries," the buyside executive said. The executive said the NYSE's Thain was taking these actions because he wants to curry favor with the specialist constituency so it will support him in the NYSE's expansion plans. He also predicted institutional investors are going to be hesitant to use the new NYSE hybrid market and they will look more closely at NYSE competitors.

"It's not going to be a great place to post limit orders," the buyside executive warned.