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August 11, 2008

Unshackled

NYSE specialists to lose constraints on trading

By Peter Chapman

The New York Stock Exchange, in the second major revamping of its marketplace in the past four years, intends to remove some of the restrictions on the trading activities of its specialists in the hopes of clawing back order flow lost to other market centers.

Bowing to complaints by specialists that they are too hemmed in by outdated rules to make a living, the exchange is overhauling a group of rules that have long served to make the specialist a de facto servant of the Big Board.

The proposal transforms the specialist into an extension of his firm's proprietary desk, leaving him to trade with his own best interests at heart. No longer a facilitator or trader of last resort, the specialist, the exchange believes, will be motivated to both quote and trade aggressively. That, in turn, will attract more orders and lead to more executions at the exchange.

Both parties believe the changes will go a long way to ending the financial agony specialists have faced over the past four years wrought by the expansion of electronic trading in NYSE-listed shares.

Back Seat

The overarching goal here is to aggregate liquidity and make the specialist more effective at the point of sale," says Todd Abrahall, NYSE vice president and specialist liaison. "Now that they don't have to yield to other interests, they will be incented to quote."

Under the exchange's complex set of rules that determine who gets to participate in which trades, the specialist frequently takes a backseat to floor brokers and upstairs traders. The proposal recasts the specialist as a "designated market maker" and puts his quotes on equal standing with those of floor brokers and upstairs traders.

At the same time, the NYSE is proposing to rescind the specialist's decades-old "negative" obligation that requires him to trade only when necessary. Now he will be able to trade opportunistically. To do that, the exchange will also relieve the specialist of his role as a broker's broker. He will no longer act as agent for floor broker or DOT orders.

To complement his newfound ability to risk his capital as he sees fit, the exchange is also proposing to eliminate rules that constrained his ability to hedge his risks. Under the proposal, the specialist would be able to use derivatives and trade on other market centers.

In addition, the Chinese wall that stood between the specialist's floor trading business and his firm's upstairs proprietary desk will be knocked down almost completely. The two operations will be able to work in tandem, with a central risk-management unit coordinating the activities of both.

To put a little icing on the cake, the exchange is backing away slightly from its long-cherished trade allocation model based on parity. It will offer those traders who set the best price-specialists, floor brokers or upstairs traders-a bigger piece of the action than they now get. The concept of time priority-standard practice at most other public markets-will play a bigger role in the system.

The upshot of all these changes is to make the specialist a competitor rather than a facilitator. He will be free to compete against floor brokers and upstairs traders. He will also be competing against market makers on other exchanges and ECNs.

No First Look