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January 31, 2008

New NYSE Rules Attract Lehman

By James Ramage

New York Stock Exchange rule changes that would favor specialists lay behind Lehman Brothers' decision to enter the floor market-making business.

Lehman said it can run a profitable market-making business on the NYSE floor if the Big Board ultimately relaxes rules governing specialist behavior. That includes rules affecting capital levels, hedging and parity, among others, according to a knowledgeable Lehman source.

Lehman in December inherited the technology, personnel and about 400 NYSE-listed issues formerly owned by Van der Moolen Specialists USA, a subsidiary of Van der Moolen Holdings. The Netherlands-based firm gave the business to Lehman for next to nothing, according to Paul Vroling, chief financial officer for Van der Moolen USA, after closing in November.

VDM said it discontinued its specialist business because it wasn't ever expected to return to profitability, according to Vroling. Instead, he added, VDM will concentrate on its U.S. brokerage and trading businesses.

"We don't see a quick change in the market conditions," Vroling said. "This will continue in 2008, and we don't want to carry these losses anymore." Nor was it interested in investing in a business that it saw as having a grim future.

Lehman, however, has other ideas. "We would not have been interested if we didn't believe there were changes that the exchange was supportive of and working toward," the Lehman source said. "Things have changed and the market has evolved, and the leadership of the NYSE, and others, have really taken a more proactive view on how to make it a more competitive, transparent and open market structure, and we're interested in that."

Other specialists, in addition to Lehman, are also hoping NYSE president Duncan Niederauer is successful in his attempt to grant specialists trading parity with floor brokers when prices are the same. Currently, floor brokers' trades take priority over specialists', regardless of who set the price.

Separately, Lehman and others are hopeful the NYSE will allow specialists to hedge in multiple instruments-and not just the underlying securities in which they are currently transacting-during trading hours. The Securities and Exchange Commission in July approved an NYSE proposal to let specialists hedge during after-hours trading.

Lehman, a longtime brokerage presence on the NYSE floor, enters the market-making field at a perilous time. The specialist business has shrunk markedly as more trading has moved off the exchange due to Regulation NMS, despite the NYSE's attempt to compete through its Hybrid market. SIG Specialists, the market-making division of Susquehanna International Group, also closed its doors at the Big Board. Specialist participation rates plummeted to 3.9 percent of all NYSE volume in December 2007, from 15.1 percent in August 2002.

One industry veteran observed that Lehman didn't buy the specialist business to make money trading; it bought VDM for the potential to convert listed companies into investment-banking customers.

Lehman now employs roughly 43 specialists, most of whom moved over from VDM Specialists.

NYSE Specialist Firms and Their Listed Companies

Banc of America Specialist 350

Bear Wagner Specialists 381

Kellogg Specialist Group 443

LaBranche & Co. 541

Lehman Brothers 400

Spear, Leeds & Kellogg Specialists 500

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