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August 14, 2007

Big Board Wants New Rules For Its Specialists

By Peter Chapman

The New York Stock Exchange is undertaking a program to improve the quality of its marketplace by revamping the rules that govern specialist trading.

Price improvement is down and volatility is up at the Big Board, a subsidiary of NYSE Euronext, so management is working with the Securities and Exchange Commission to introduce changes to the restrictions and incentives that govern specialist activities. In addition, the New York is introducing a new program to evaluate specialists' quarterly performance based on statistics, rather than floor broker reports. These three-month check-ups are used by the exchange to determine stock allocatins.

In June, Duncan Niederauer, president and co-chief operating officer at the NYSE, told analysts that five years ago "the opportunities outweighed the obligations" for specialists. But today "the reverse is true."

Times are hard for specialists as they are finding it difficult to make money under the New York's new electronic "hybrid" platform. Some have not developed adequate technology. One major firm, LaBranche & Co., recently announced it is exploring "strategic alternatives." That could mean a sale, sources note.

Niederauer wants to convert the specialists into "primary market makers," a category of dealer used by other exchanges that is similar to the NYSE specialist but has fewer obligations.

One of Niederauer's goals is to eliminate the rules about how much price improvement specialists must provide. "No market maker in a stock that is 5 cents to 6 cents wide is going to improve the price by 3 cents just to provide price improvement," Niederauer said. Those rules have "eliminated quote competition inside the quote," he added.

Under the hybrid marketplace, price-improvement levels have declined. Specialists' participation rates, a measure of how frequently they take the other side of a trade, are around 3 percent. Pre-hybrid they were about 12 percent.

The NYSE, which began paying specialists for supplying liquidity last year, will continue to do so. But it will change the way it calculates those payments. Instead of market share, the exchange will base compensation on such market quality factors as level of price improvement; level of size improvement; management of volatility; tightness of spreads; liquidity at the best bid and offer; and percentage of time spent at the NBBO.