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November 13, 2007

Dealers Clamor for Trading Parity

By Peter Chapman

The Securities and Exchange Commission could approve fundamental changes to exchange rules that would give specialists and market makers more latitude to compete with exchange customers.

Any changes are likely to especially impact dealers on the New York Stock Exchange and the International Securities Exchange.

At the heart of the matter is whether or not exchange dealers should be able to trade on parity with exchange customers. Currently, some exchanges-including the NYSE and many of the options exchanges-have rules requiring dealers to trade after brokers when quoting at the same price.

In a speech at this year's Security Traders Association annual conference, Erik Sirri, the SEC's director of market regulation, said that the commission was under pressure from exchanges to approve their plans to liberalize certain rules governing market-maker behavior.

"We are being asked to adjudicate questions that go to the heart of the basic regulatory framework for exchanges," he told attendees.

The exchanges, Sirri explained, are concerned about their competitiveness vis-a-vis market centers such as alternative trading systems that are not subject to the same stringent rule sets as exchanges.

To improve the quality of their markets, the exchanges maintain, they need to loosen some of the rules governing market-maker behavior. If they don't, the market makers will not supply liquidity as aggressively as the exchanges require.

The problems faced by exchange dealers are twofold, Sirri explained. First, they no longer have the advantage of being at the center of the action, as trading has become more fragmented.

Although Sirri did not refer to NYSE specialists by name, sources note that the specialists have lost their monopoly over the information flow in their stocks, because more trading in NYSE-listed names has moved away from the exchange.

Second, exchange dealers are frustrated by the subordinate positions they must often take vis-a-vis exchange customers, Sirri said. Under exchange rules, when bidding or offering at the same price as an exchange broker, dealers must often let the broker trade first against any incoming contra-side order. Again, Sirri didn't refer to any exchanges specifically. But both the NYSE and ISE have pressed the SEC on the issue of dealer parity.

The ISE, for instance, has sought to win parity for its market makers when competing with so-called "professional customers." Currently, most options exchanges allow public customers to go to the front of the queue when they are quoting the best price.

As for the NYSE, officials there say it is in negotiations with the regulator over allowing Big Board specialists to trade on parity with all customer orders.

Despite regulators' long-held preference for relegating dealers to the back of the queue, Sirri appeared sympathetic to the exchanges' requests.

"Exchanges produce something that is not produced elsewhere," Sirri said, "and that is price.' It's an important externality. Many others free-ride off of it. We have an obligation to protect that externality."

At least one exchange executive is encouraged by the SEC's stance on liberalizing dealer rules. "They are moving in the right direction," Larry Leibowitz, NYSE Group's chief operating officer of U.S. products, told Traders Magazine.