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February 16, 2007

SEC Cuts Big Board Specialists Some Slack

By Peter Chapman

The Securities and Exchange Commission relieved New York Stock Exchange specialists from certain trading restrictions.

The regulator approved a Big Board proposal to amend its Rule 104 to permit specialists to trade for their own accounts in a less constrained fashion. The SEC cited changes to the trading environment brought on by Regulation NMS as the basis for its decision.

Specifically, the amendments give specialists latitude in two areas. First, they eliminate the requirement that specialists satisfy their "negative obligations" on a trade-by-trade basis.

Second, the amendments let specialists trade with (as opposed to against) the direction of the market regardless of the price at which they trade. Previously, specialists could not buy on an uptick or sell on a downtick when increasing or establishing a position without the consent of an NYSE floor official.

Along with specialists' "affirmative obligation," which requires them to stabilize prices by trading, their negative obligation is a key principle that guides their trading behavior. The negative obligation requires specialists to refrain from trading unless necessary to stabilize prices. Previously, the specialists were judged as to whether or not they were living up to their negative obligations on a trade-by-trade basis. Also, they could not buy as stocks were increasing in price or sell as they fell when increasing or establishing a position without NYSE approval.

The Big Board argued that the implementation of its hybrid market model and the SEC's Reg NMS made these two parameters obsolete. An increase in volume and the speed of trading would make monitoring every trade and every tick too difficult and less relevant.

The SEC agreed, mostly. It permitted the NYSE to monitor specialists' compliance with their negative obligations on a broader "patterns and practices," rather than on a trade-by-trade, basis. It also gave specialists, on a trial basis, permission to trade with the market at any price in the performance of their negative obligation. A pilot will run through June 30. Compared with its problems in securing SEC approval for its hybrid marketplace, the NYSE faced little opposition to amending Rule 104.

Its sole critic was a Chicago consultant named George Rutherfurd who argued that the rule changes would result in the insertion of specialists into trades where they did not belong, which would force public investors to miss out on fills. Rutherfurd believes the changes amount to a rescission of the specialists' negative obligation.

The SEC said that the elimination of the tick requirements allow for a "significant shift in the roles and obligations of specialists." Because of that the SEC is only liberalizing the rules for stocks in the S&P 500 and a few others on a trial basis. Permanent liberalization depends on the result of an SEC examination of market quality figures at the end of the trial.