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Bowing to complaints by specialists that they are too hemmed in by outdated rules to make a living, the exchange is overhauling a group of rules that have long served to make the specialist a de facto servant of the Big Board.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
The exchange is not letting the specialist completely off the hook. Indeed, it is placing new responsibilities on his shoulders and taking away a major privilege. Under the proposal, he will be required to make two-sided markets at least part of the day. Also, he will lose his “look at the book,” which gave him a first peek at incoming orders.
The specialist will still be held to his “affirmative” obligation to trade in order to smooth out fluctuations in prices and when no one else is willing. But the rule has been watered down by a widening of the New York’s “depth guidelines,” which dictate the range within which specialist may allow prices to fluctuate.
Operators of two of the exchange’s six specialist firms have already publicly weighed in on the proposal. Lehman Brothers signaled its approval last December when it bought Van der Moolen Specialists USA. At the time, a Lehman executive told Traders Magazine that “market structures evolve, and the leadership of the exchange has a vision that we share as to how that market structure can be competitive.”
Goldman Sachs, operator of the Spear, Leeds & Kellogg specialist firm, is also bullish on the future. It told shareholders in its first-quarter report that it expects the NYSE “to recapture approximately one-half of the market share that it lost in 2007.” Goldman also believes “we will increase the market share of our NYSE specialist business and, as a designated market maker, the profitability of each share traded.”
But, why compete under the NYSE’s roof and not somewhere else? Wouldn’t it be easier to just make a market in IBM on Nasdaq or BATS, where the restrictions are minimal and the market pays for liquidity?
NYSE specialists do actually get paid for supplying liquidity under the NYSE’s Liquidity Provision Payment plan (see sidebar), but the monthly payment is tiny compared with the 20 cents per 100 shares paid by other market centers. So what’s the attraction of the NYSE?
One head trader at a bulge shop, who used to trade at the NYSE, says: “The amount of flow specialists are seeing has gone down pretty dramatically, but [under the proposal] their ability to monetize what they see in that flow will go up pretty dramatically. It’s a good situation. It’s still a pretty big marketplace.”
Neil Fitzpatrick, chief operating officer of Citadel Execution Services, says his firm is seriously considering applying to become a designated market maker. “There is order flow that still goes to the New York Stock Exchange that will always go to the NYSE first,” he says. “It is not necessarily going to be routed to an ECN.” This flow is also often seen as higher quality than what’s encountered on ECNs, Fitzpatrick adds. ECN orders may be from stat-arb shops that a wholesaler such as Citadel might prefer to avoid.
Because the exchange is not at the national best bid or offer often enough, Fitzpatrick says, that flow either doesn’t make it to the New York or is routed away once it arrives. “The New York is saying: ‘We need to get people in here who can create the NBBO and will be rewarded for doing so.'”
Not Zero-Sum
The Citadel executive also attributes the attraction to the fact that each market center is distinct in its own way. A market maker can make money trading on the NYSE, for instance, simply because it is not Nasdaq or BATS or another marketplace. “It’s not a zero-sum game,” Fitzpatrick says. “Every new destination that has a reasonable amount of liquidity is a potential place to quote.”
The New York’s proposal, which must be opened to industry comment and approved by the Securities and Exchange Commission, furthers the transformation of the specialist that began with the exchange’s Hybrid proposal in 2004. Indeed, it is the latest rule change in a series of changes since 2004 giving the specialist freer rein (see sidebar). Ever since the introduction of Regulation NMS and the NYSE’s Hybrid marketplace, the exchange has argued that the old rules governing specialist behavior had lost their relevance.
Before Hybrid, the specialist acted primarily as an agent for other brokers, an auctioneer and a dealer when necessary. Any trading for his own account was done to minimize price fluctuations and in the event that there were no other buyers or sellers. His role as a dealer was to maintain a “fair and orderly market,” And he was not permitted to trade opportunistically.
Surge
But with the introduction of the Hybrid market, the specialist became more of a competitor and less of a facilitator. Although he still had to refrain from trading unless absolutely necessary, the specialist could compete more freely against floor brokers for fills. At the same time, the surge in electronic trading that accompanied Hybrid rendered most of his agency and auctioneer functions obsolete.
Despite all the tweaks to the rules over the past four years, the switch to electronic trading at the New York has proved too much for the specialist. Any advantages he gained have apparently done little good. His participation in the market is at an all-time low, as is his profitability. Two specialists, Van der Moolen and Susquehanna, abandoned their books entirely. All specialist firms have been slimmed down through layoffs.
The near-total replacement of open-outcry trading with automatic executions has relegated the floor to not much more than office space. Brokers and dealers transact almost all of their business over computers. Hybrid effectively turned the exchange into just another ECN, marginalizing the specialist.
On the surface, the exchange’s proposed new model resembles those of the NYSE’s all-electronic competitors. Aggressive market makers will bring in the business. Trading on an electronic book will be open to all comers. But when it comes to the relative status of its constituencies-there are three: floor brokers, market makers and upstairs traders-the New York’s philosophy is decidedly different.
For the most part, the treatment of traders by ECNs and ECN-like exchanges is democratic. Whoever sets the best price first gets filled first. Whoever sets it second gets the next chunk, and so on. They use a strict price-and-time-priority schema that does not discriminate against any given class of trader.
At the New York, the process is very different. Whoever sets the best price first does get filled first. But that fill may be for only 100 shares. At the New York, time priority is good for only one trade. If, for example, the first man is bidding for 1,000 shares and a 100-share sell order comes in, that’s all his priority gets him. Any subsequent incoming sell orders are shared with the pack.
This sharing process is known as “parity” at the exchange. It benefits those floor brokers with “go along” orders. Some brokers are prohibited from setting the price by customers who are afraid of standing out, and therefore trade as volume executes. At prices away from the BBO, there is absolutely no time priority. All allocations are done on parity.
This divergence from strict price-and-time priority goes even further, as individual traders must often subordinate their interests to those of other trader groups. The specialist, for instance, must always yield to orders from upstairs traders at the same price. Even if he sets the BBO first, the specialist must forfeit the trade to the upstairs trader. And because of that rule, the specialist often ends up yielding to floor brokers as well.
Fewer Trades
For their part, upstairs traders are essentially second-class citizens compared with floor brokers. While individual floor brokers are treated equally during the allocation process, individual upstairs traders are treated as a group. The group then splits up its share allotment based on strict time priority.
Under the exchange’s new proposal, the standing of the upstairs trader is likely to get worse. Because the specialist will not have to yield to the book, the upstairs trader will likely participate in fewer trades. And when he does participate, he will likely receive fewer shares under the allocation process.
Putting the specialist on parity with the upstairs trader (and, by extension, the floor broker) is the right thing to do, according to the NYSE’s Abrahall. “If I am asking this group of firms to set the best market and someone else joins at the price, it is unfair to kick them to the back of the line,” he says. Abrahall points out that under current rules, the specialist is on parity with floor brokers as long as there is nothing on the book. The problem, though, he adds, is that there is always something on the book, and therefore the specialist yields to both parties.
Some upstairs traders are not happy with the direction the exchange is taking with its proposal, but most contend they have plenty of other venues on which to trade. “They have every right to do what they are doing,” says Dan Mathisson, head of Advanced Execution Services at Credit Suisse. “But there are plenty of other places you can go. It’s not like the old days when they changed the rules. You didn’t have an alternative when they had 80 percent of the volume.”
A block trader at a large broker-dealer expects little resistance from the trading community to the changes. “They understand what is going on,” he says. “The New York is trying to preserve its market share. The world that existed five or seven years ago doesn’t exist anymore. Steps need to be taken.”
Under the proposal, the exchange is not just eliminating the requirement that the specialist yield to the book when he sets the best price-it is also sweetening the pot when he sets it. Being first in line today can be a meaningless experience as priority is only good for one trade. In the future, though, it could stand for a lot more.
The exchange is now proposing to guarantee the trader who sets the best price-specialist, floor broker or upstairs trader-up to 15 percent of the shares in any trade (round lots only). And the offer does not end after the first trade.
If, for example, the first man is bidding for 1,000 shares and a 100-share sell order comes in, he gets the shares. If a second 100-share order comes in, he gets those shares, too. If a 200-share order then comes in, he gets 100 shares and the next man gets 100. If the next incoming order is for 2,000 shares, the first man gets 300 shares, or 15 percent, and splits the rest with those behind him in line. He continues to trade until his order is filled or no more sell orders at that price come in. If the sell orders dry up but reappear later at the trader’s price, he has priority once again.
The change moves the NYSE a little closer to competitors that offer strict price-time priority books and a little bit away from its parity regime. It is not only meant to encourage price setting, but also the display of greater size.
“If you make the market,” says Dick Rosenblatt, chief executive of agency brokerage Rosenblatt Securities, “until you have completed that 1,000 shares, you get more than the other participants. Even if the market moves away from you and then an hour later moves back to your price, you still get that 15 percent benefit.”
For the specialist, the parity and priority proposal goes hand in hand with the NYSE’s plan to eliminate the specialist’s negative obligation. That decades-old rule bars the specialist from trading except to stabilize prices. The rule was established to counteract the advantage the specialist gained by his position at the central collecting point for all incoming orders.
Heyday
But now, with the sharp decline in orders sent to the exchange-it trades only a quarter of all NYSE-listed shares versus 80 percent in its heyday-the specialist no longer has an unfair advantage, the NYSE and supporters of the specialist argue. First, he has access to less information, and more information is widely available to all traders.
And second, his control over trading at the post has largely disappeared. “There was a time when the specialist controlled the tick,” a former NYSE specialist explains. “No trade happened until he allowed it to happen. But as he lost control of the tick, the rules became increasingly irrelevant.”
The NYSE holds that the specialist must be allowed to look out for his own interests. That way he will be encouraged to commit his capital to drive flow back to the exchange. If he’s not freed to trade, the NYSE said, he’ll abandon the exchange.
Lehman Brothers certainly sees it that way. “The existing specialist model is not sustainable,”
the Lehman executive says. “But a model where certain changes take place, where the designated market maker can really add value, would obviously lead to a valued return.”
Under current NYSE rules, the specialist is still legally an agent for floor brokers and incoming DOT orders. Practically speaking, however, he has little to do with floor broker orders, while exchange systems have largely taken over the handling of DOT orders. So as part of the plan to eliminate the specialist’s negative obligation, the exchange also intends to eliminate any rules that make the specialist “the broker of record” for these orders. In other words, he will no longer act as agent.
Parity with the book and the rescission of the negative obligation could go a long way to making the role of designated market maker an enticing one, but the biggest transformative event may be the watering down of the NYSE’s Rule 98. This is the rule that requires the specialist unit to be both legally and functionally separate from the rest of his firm.
The rule creates a Chinese wall between the trading activities of the specialist unit and the trading and risk-management activities elsewhere within the firm. It also bars the sharing of information between desks, making it impossible for a firm to incorporate specialist positions into its overall risk-management work.
Rule 98
Rule 98 also prevents the specialist from leveraging his parent’s capital, analytics and other related expertise. “That wall is 100 feet high right now,” Abrahall says. “We’re bringing it down to where it should be.” The exchange is not seeking to kill Rule 98, just to amend it. Any amendment will effectively gut it, though.
The Rule 98 proposal is big enough that the New York felt it necessary to present it to the SEC separately from its main proposal overhauling NYSE rules. For its part, the regulator has already indicated a level of comfort with the changes. Last December, it gave the New York temporary approval to eliminate certain provisions of Rule 98 when Lehman announced its purchase of Van der Moolen.
Behind the overhaul of Rule 98 is a desire by the exchange and firms controlling specialist units to integrate the specialist’s risk-taking activities with those of the rest of the firm. That way the specialist unit will increase his ability to take on positions on the floor.
Today, the specialist can only hedge his positions within the confines of the New York Stock Exchange, which often entails waiting until an offsetting trade becomes available. Plus, he can only hedge by taking offsetting positions in the actual stocks. He can’t use options, for instance.
Under the proposal, he would win three more alternatives: He would be able to transfer his risk to an upstairs risk-management desk. He would be able to trade at other market centers. And he would be able to use derivatives. The NYSE is also proposing an exemption to Rule 105, which bars specialists from trading with options and single-stock futures.
Overall, this change will erode the independence of the specialist operation, as its activities are integrated with those of the rest of the firm. The rule will allow so-called “aggregation units”-departments that separate certain trading activities at various parts of a firm-to coordinate the trading of specialist units with proprietary desks. A risk manager will act as a middleman between the two desks, watching the positions of both and making trading decisions. The two desks will still not be able to communicate with each other. But that possibility is open for future consideration, according to the filing.
Hedging
The changes will permit the specialist to transfer his risk to the firm’s prop desk and visa versa. However, coordination of trading and risk management will be limited to the specialist and prop desks. Risk managers will not be permitted to take into account positions held by customer-facing desks such as the block desk or Nasdaq market-making desk.
Easier hedging will translate into more risk-taking by specialists, the exchange believes. “At present, they can only unload their positions on the exchange floor,” Abrahall explains. “They have to wait for the liquidity to come to them. [Under the proposal] they always have an outlet. We can allow them to get the liquidity through their upstairs aggregation unit. They will not be constrained from making a better market.”
Duncan Niederauer, chief executive of NYSE Euronext, sees the move by specialists to transfer their risk-management work upstairs as further reducing the need for personnel on the floor. “It would not surprise me,” he recently told analysts, “as the market model continues to evolve and we continue to embrace technology, that more of the risk management can be done off the floor. I think that would be positive for liquidity provision.”
Assuming the New York gets what it wants-a group of aggressive market makers-will it make any difference? Granted, the designated market-maker initiative isn’t the only front on which the New York is tackling its market share problem, but it is a biggie.
“The orders will come in more frequently,” Abrahall says. “They will be of bigger size. The customer will get more size done at better prices. That is how I view victory. And that, of course, helps your market share.”
Goldman also expects a jump in the NYSE’s market share. Citadel’s Fitzpatrick is cautiously optimistic. So is Rosenblatt, the broker. But others aren’t so sure. Many executives Traders Magazine spoke with are skeptical. They believe the ship has sailed. Jamie Selway, chief executive of institutional brokerage White Cap Trading and the former chief economist at Archipelago, predicts that the NYSE’s market share will drop to 20 percent.
“The New York is potentially getting better specialists,” Selway says. “It is getting the type of specialist one would need in this day and age. But limit-order traders are probably more important. The New York is helping the less-important constituency and hurting the more-important one. One guy will be very important and very happy and will increase his business on the NYSE. But what happens to the rest of us?”
The exchange expects to phase in the rule changes during the third and fourth quarters.
SIDEBAR #1: The Evolution of the Specialist
The New York Stock Exchange is making headlines with its recent plan to transform the specialist from a kind of indentured servant into a trader with free will. But a closer look shows that the exchange has been quietly chipping away at the restrictions on specialist trading for the past four years. With the introduction of the NYSE’s Hybrid marketplace in 2004, the exchange has argued that the old rules governing specialist behavior no longer apply. Below is a laundry list of some of the key rule changes.
> February 2006 The exchange “reminded” the industry and the Securities and Exchange Commission that it had always interpreted its Rule 108 to permit specialists to trade along with the crowd when building a position as long as the floor broker did not object. Previously, it was always accepted that the specialist could trade on parity with the crowd when reducing a position.
> June 2006 The exchange reduced the minimum amount specialists had to display when using reserve orders. Before the change, specialists had to post at least 2,000 shares if using an iceberg order. Now they would only have to post 1,000 shares, the same as floor brokers.
> Fall 2006 The exchange relaxed the strictures of the specialist’s negative obligation. The exchange stopped monitoring compliance on a trade-by-trade basis and also permitted them to build positions more easily in active stocks. To that end, it replaced a restrictive tick-test-i.e., no purchase on an uptick-with a requirement that the specialist reduce any position shortly thereafter.
> September 2006 The exchange made it easier for a specialist to grab incoming orders by reducing the amount he had to pay in the form of “price improvement.” The exchange did away with its guideposts requiring the specialist to pay either 2 cents or 3 cents better than the NBBO, depending on the bid-ask spread. Now the specialist only has to pay 1 cent, the same as a floor broker.
> September 2006 The NYSE reduced specialist capital requirements.
> March 2007 The NYSE made it easier for the specialist to comply with his affirmative obligation that requires him to take positions in order to maintain a “fair and orderly market.” By widening the parameters of its so-called “depth guidelines,” the exchange permitted specialists to let stocks fluctuate more. That reduced the amount of trading specialists had to do to stabilize prices, which, in turn, lowered their risk.
> July 2007 The exchange lifted the restrictions on specialist trading after hours. Previously, because the specialist acted as agent for orders on the book, he couldn’t trade ahead of any orders that might be still sitting there after the market closed. This hampered his hedging activities, specialists complained. Now, the specialist could trade in those stocks between 6:30 p.m. and 9:15 a.m. the next day. The change to Rule 92 aligned it more closely with Nasdaq’s Manning rule, which also covers trading ahead by market makers.
> September 2007 The exchange further relaxed the rules governing the specialist’s negative obligation by permitting him to build positions more easily in all stocks-not just active ones. The specialist was still subject to the negative obligation, but could more easily build a position if deemed necessary to maintain a “fair and orderly market.”
> October 2007 The exchange lowered the minimum display size from 1,000 to 100 shares for the use of reserve orders for both floor brokers and specialists. The exchange argued that the 1,000-share threshold deterred specialists and floor brokers from using reserve orders.
> December 2007 The NYSE temporarily eliminated part of its Rule 98 that requires a broker-dealer’s specialist arm to be run separately from the rest of the firm. The move was made to accommodate Lehman’s acquisition of Van der Moolen and any other takeovers that might be imminent.
> February 2008 The NYSE reduced specialist capital requirements.
> June 2008 The exchange proposed to eliminate the specialist’s negative obligation and the provision requiring him to yield to DOT orders. It would also relax the restrictions of Rule 98 that keep the specialist organization legally and functionally separate from its parent company. It will also let specialists better hedge their positions.
SIDEBAR#2: Dollars for Dealers
The New York’s plan to win back market share by encouraging specialists to quote aggressively relies heavily on freeing them from the restraints on their proprietary trading. But the exchange is not averse to making outright cash payments to the traders.
Last year, the New York took a page from its competitors’ books and started paying its specialists for providing liquidity. It transformed a no-strings-attached revenue-sharing program originally intended to replace specialists’ lost commission income into a Liquidity Provision Payment (LPP) program.
To benefit, specialists must quote frequently and in size at the National Best Bid or Offer. Under the program, the New York pays them approximately 1.5 cents per 100 shares (17 percent of transaction fees of 8 cents per 100) plus all of the market data revenues it earns that are attributable to quotes. Although it is similar in concept to the rebate programs of its rivals, the LPP doesn’t come close to the roughly 20 cents per 100 shares paid by most venues.
(c) 2008 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
http://www.tradersmagazine.com http://www.sourcemedia.com/
