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December 6, 2006

The SEC Approves New Specialists' Obligations

By Gregory Bresiger

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.

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.