From: George Rutherfurd
(This letter supplements my November 1, 2005 and November 17, 2005 letters. The thrust of the comment is addressed to SR-NYSE-2005-74, but is also being submitted under SR-NYSE-2004-05 because the substantive issues have arisen in the context of that rule submission).
I am writing in response to the NYSE's December 7, 2005 resubmission of SR-NYSE-2005-74. In particular, I am writing to express my dismay at the NYSE's attempted "response" to the objections I have made to this proposal in earlier correspondence.
The NYSE's response is highly selective, as there is no discussion whatsoever of my point that this proposal contradicts the NYSE's own position of several months ago. Furthermore, there is no discussion of my point that specialist parity acquisition tradi ng can never be reconciled with the negative obligation.
These are major objections to the NYSE's proposal.
As I demonstrate in detail below, this proposal has not been "properly designated" as a rule interpretation, but rather constitutes a substantial revision to Rule 108.
The NYSE must submit a formal amendment to the text of Rule 108, and must be ordered to cease and desist permitting specialist parity acquisition trading unless and until it obtains SEC approval of a properly-submitted amendment to the text of Rule 108.
The NYSE's "Interpretation" of Rule 108 Is Clearly Inconsistent with the Plain Language of the Rule
In my earlier correspondence, I noted the plain language of Rule 108:
"No bid or offer made by a member or made on an order for stock originated by a member while on the floor to establish or increase a position in such stock for an account in which such member has an interest shall be entitled to parity...."
This language, as applied to specialists today, can be paraphrased as "No specialist shall be entitled to parity when establishing or increasing a position." The key phrase, clearly articulated in the rule, is "shall be entitled to parity." (The NYSE makes the nonsensical point that the word "shall" does not appear in the rule; it obviously does, not that this point, in itself, is especially dispositive of anything).
I have noted that there is no ambiguity whatsoever in the rule's simple language, nor any suggestion that the bar to being entitled to trade on parity can in any way be "interpreted" to provide a "conditional entitlement" (e.g., specialist parity trading permitted with floor broker permission or in the absence of floor broker objection).
In response, the NYSE presented the truism that statutory interpretation must begin with the words of the rule or statute, and that the words of a rule or statute should be given their plain meaning, wherever possible. I couldn't agree more.
The NYSE then presents two standard dictionary definitions of "entitle" which it asserts support its position. The NYSE further asserts that its position is further supported "by the well-accepted canon of statutory construction that rule-writers are presumed in any rule to have said what they meant and meant what they said." The NYSE even provides (footnote 7) a Commission-approved NASD "precedent" which it asserts fully supports its position.
I must confess I read this material several times in a state of disbelief. The plain language, dictionary definitions, canon of statutory construction, and NASD "precedent" fully supp ort my position, and completely undermine the NYSE's.
1. The Plain Language of the Rule
The NYSE quite fairly frames the matter: "At issue is whether Rule 108(a) on its face prohibits specialists from trading on parity when they are establishing or increasing their positions." The NYSE itself provided the clear answer to this question in Amendment 5 to SR-NYSE-2004-05 (at page 14), submitted to the Commission less than six months ago (June 17, 2005): "Currently, Rule 108 prohibits the specialist from trading for its proprietary account on parity with the Crowd in situations where the specialist is establishing or increasing a position." What could be clearer than this?
Furthermore, the NYSE did not at all suggest that this clearly-acknowledged prohibition could be overcome by an "interpretation." Rather, the NYSE acknowledged the obvious, namely that a formal rule amendment was requi red here, in its statement (page 14), "The Exchange proposes to amend Rule 108 to eliminate that restriction...." On page 15, the NYSE further refers to "the proposed change to NYSE Rule 108."
How can the Commission or the public possibly believe that there is now a "longstanding interpretation" of Rule 108 permitting specialist parity acquisition trading when the NYSE itself did not believe this as recently as several months ago? How can the Commission and the public accept the NYSE's current assertion that Rule 108 does not "prohibit" specialist parity acquisition trading when the NYSE itself said that it did, and that formal amendment of the rule was required?
I raised these rather obvious points in earlier correspondence, but, astonishingly, the NYSE (apparently having no answer) simply ignored these points completely in its attempted "response" to my comments. This clearly and fairly raises the question of w hether the NYSE is acting in good faith.
But it gets worse. Not only has the NYSE failed to acknowledge to the Commission and the public its prior, contradictory position, but it has affirmatively misrepresented that position, a singularly duplicitous tactic. On pages 3-4 of SR-NYSE-2005-74, the NYSE refers to Amendment 5 of SR-NYSE-2004-05, and makes the following statement:
"As noted in that filing, the proposed change comports with, and would incorporate into rule text, the Exchange's longstanding interpretation of Rule 108(a) as permitting a specialist to be on parity with orders in the Crowd when the specialist is establishing or increasing a position, provided that the brokers representing orders in the Crowd permit to the specialist trading along with them by not objecting to such participation."
This is a truly astonishing sentence, an attempt at a sle ight of hand worthy of the great Houdini himself. Notwithstanding the "as noted in that filing" representation, there is no reference whatsoever in that filing to any "longstanding interpretation." As I noted, what that filing does state, clearly and unequivocally, is that Rule 108(a) does prohibit specialist parity acquisition trading, and that a formal amendment to the rule is required to remove this restriction.
The SEC staff, on behalf of the public, should be outraged at this. (Far from engaging in "histrionics", as the NYSE staff would have it, I am perhaps guilty of understatement).
As I demonstrated in my earlier correspondence, the NYSE stated in Amendment 5 that Rule 108(a) prohibited specialist parity acquisition trading, that formal rule amendment action was required, but the practice was already occurring anyway. Faced with the realisation that they had, doubtless unwittingly, effectively acknowledged that i llegal trading was taking place, the NYSE staff began a mad scramble to "sanitise" this mess, culminating in the appearance of a "longstanding interpretation" that surfaced (my research indicates) for the first time ever on October 25, 2005, the first iteration of SR-NYSE-2005-74. And the NYSE's Board of Directors has been kept in the dark about all of this, as the NYSE staff (apparently to protect themselves) have the sheer "chutzpah" to treat this matter as a routine rule interpretation.
As the old saying would have it, the NYSE is obviously "hoist by its own petard" here.
It really is that simple.
2. The Dictionary Definitions
As noted above, Rule 108(a) provides, in essence, that "No [ specialist] ...shall be entitled [to engage in parity acquisition trading]." Notwithstanding this simple, straight-forward language, the NYSE staff are purporting to "interp ret" the rule as meaning "Every floor broker shall be entitled to engage in parity acquisition trading unless a floor broker objects." On its face, the NYSE's interpretation is clearly absurd, an attempt at twisting language beyond any recognisable form. The NYSE is clearly attempting a substantive revision of the rule in the guise of an "interpretation."
How does the NYSE attempt to rationalise this absurdity? The essence of the (hitherto unknown) "longstanding interpretation" is the following:
"But, because [Rule 108] only speaks to specialists not being 'entitled' (i.e., not having an unconditional right) to be on parity rather than flatly prohibiting them from being on parity, the rule, by its terms, does not preclude specialists from trading on parity when establishing or increasing their positions if brokers in the Crowd raise no objections" (pages 5-6).
The critical element here is the NYSE staff's desperate attempt to find a user-friendly definition of "entitle" that would permit them to "interpret" a rule that says "no can do" as meaning "can do absent objection."
The NYSE provides two dictionary definitions, neither of which, in substantive effect, is all that different from the one I noted in earlier correspondence. One NYSE definition is "to furnish with a right or claim to something." The other definition, virtually the same, is "to give a right or legal title to." Neither definition purports to modify the word "right."
The test here, of course, is to "plug" the NYSE's definitions into the rule, remembering that the rule language is not just "entitle", but "shall be entitled." The result of the "plug in" exercise demonstrates how truly fatuous the NYSE staff's position really is.
Subs tituting the NYSE's first definition for the word "entitle", we would have a rule that reads, "No specialist shall be furnished with a right to engage in parity acquisition trading." Substituting the NYSE's second definition for the word "entitle", we would have a rule that reads, "No specialist shall be given a right to engage in parity acquisition trading."
Both of the NYSE's own definitions clearly state (as does the current rule) that the specialist shall not be permitted to engage in parity acquisition trading. If anything, the NYSE's own definitions make the sense of prohibition even clearer and stronger (not that it is ambiguous to begin with). But the NYSE staff, in an attempt at a sleight of hand that is as idiotic as it is insulting, maintains that there is no prohibition here because the term "right" is not referred to as an "unfettered" or "automatic" right. One shakes one's head in despair at such rubbish. The NYSE's own definitions do not use words like "unfettered" or "automatic", nor would they, as they do not suggest in any way that a "right" is somehow diminished unless referred to as "unfettered" or "automatic." A "right" is understood to be unqualified, unless the expression of the right is accompanied by terms that expressly limit that right. Any such terms of limitation are, of course, conspicuously absent from Rule 108, a point I address further below under canon of statutory construction.
The NYSE staff are attempting to read into their own definitions words that simply are not, and would not, be there. The definitions, in and of themselves, clearly support my position, and the NYSE's own position in Amendment 5. The NYSE staff objected to my use of the term "intellectually bankrupt" to describe their linguistic flim-flam. Again, I confess to being guilty of understatement.
3. Canon of Statutory Construction
The NYSE staff noted the fundamental canon of statutory construction that "rule-writers are presumed in any rule to have said what they meant, and meant what they said." This is an obvious truism, and, as with the dictionary definitions, it completely undermines the NYSE staff's position.
The NYSE staff attempt, rather incoherently, to argue that because Rule 108(a) uses the term "entitle" rather than "prohibit", the drafters of the rule must not have intended to prohibit specialist parity acquisition trading. (As noted below, the NYSE staff offered no documentation whatsoever about what the original drafters of Rule 108 intended, and there is, of course, the contrary position expressed in Amendment 5).
To those of us familiar with the English language, there is obviously no substantive difference between "No specialist shall be entitled to (or be given the right to) engage in parity acquisition trading" versus "The specialist shall be prohibited from engaging in parity acquisition trading." Either formulation comes down to the following: specialist no can do.
The "logic" of the NYSE staff's position is that the word "entitled" is somehow conditional, in and of itself, even though their own definitions contain no conditional language whatsoever. The canon of statutory construction cuts in exactly the opposite direction from the NYSE staff's position. Had the drafters of the rule intended to "condition" the word "entitled", the canon of statutory construction leads to the conclusion that they would have done so expressly. The fact that the language of the rule does not condition the word "entitled" demonstrates that the rule's drafters did not intend a limitation here. The one exception in the rule, for "G" orders, indicates that when the rule's drafters intended to provide an exception, they knew how to do so, and did so expressly. The absence of othe r express exceptions can only mean, under the canon of statutory construction, that there was never any intent to provide any.
The NYSE staff are seeking to turn the canon of statutory construction on its head by their misrepresentation that "entitled" is a conditional term because "the rule says only that a member does not have an unfettered or automatic right to trade on parity" (page 8). The rule, of course, by its express terms, says absolutely no such thing. The NYSE staff cannot be allowed to read terms like "unfettered" or "automatic" into the rule when they do not appear there (as they did not appear in their dictionary definitions).
Under the canon of statutory construction, the presumption is that, if the drafters of the rule had so intended, such terms would have been expressly incorporated into the rule. The fact that such terms do not appear in the rule clearly means that the rule's drafter' s did not intend for them to be there.
By any standard, the NYSE staff's discussion here is a self-serving embarrassment.
4. The NASD "Precedent"
The NYSE staff argue that their position is supported by an NASD precedent. I wish I had been aware of this precedent when I drafted my earlier correspondence. I would have cited it myself, as it completely undermines the NYSE staff's position.
The NASD precedent (NASD MANUAL, Section 2341), as approved by the Commission in 2001, states the following:
"You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to customers under certain circumstances, a customer does not have a right to the extension."
In the NYS E staff's view, this supports their position that entitlement is a conditional term because it permits margin extensions under certain circumstances, even though the first sentence states that customers are not entitled to margin extensions.
The NYSE staff appear completely oblivious to the significant difference, as a matter of proper and appropriate rulemaking, between what the NASD did with Section 2341 and what the NYSE staff are attempting to do in SR-NYSE-2005-74. The NASD approach is a model of proper rulemaking. The NASD stated a general rule in the first sentence, but then expressly conditioned the general rule in the second sentence, with all of this material clearly appearing in the plain text of Section 2341. There is no linguistic flim-flam here, nor an attempt at an "interpretation" whereby the second sentence (the condition) would have to be inferred from the first (the prohibition) without the second sentence having to appear in t he rule itself.
This is fundamental general rule/exception rulemaking, with all relevant material appearing in the rule text itself. In the NASD proposal, the reason why "entitle" does not express an absolute prohibition has nothing to do with the definition of "entitle." Rather, it has everything to do with the fact that the NASD added, in the text of the rule itself, the second sentence to modify the first.
In contrast to NASD Section 2341, with its general rule/exception structure, Rule 108 states only the general rule. It is certainly the NYSE's prerogative to propose to condition the general rule about entitlement (as it did with "G" orders), but it must, as did the NASD, place the condition in the rule text itself, and obtain prior SEC approval before permitting members to act under the condition.
The NASD precedent should be an embarrassment to the NYSE staff, as it demonstrates how c ompetent professionals go about effecting substantive rule changes by conditioning general prohibitions expressly in comprehensive rule text. The NASD precedent is in fact precedent for the proposition that the NYSE should be proceeding by formal amendment to the text of Rule 108 rather than engaging in the subterfuge of a "longstanding interpretation" that effects a substantive change to the rule without prior exposure to the public.
The NYSE Has Not "Properly Designated" This Matter As An "Interpretation"
In earlier correspondence, I noted the requirements of Rule 19b-4 and demonstrated why the NYSE had not "properly designated" this matter as an "interpretation" eligible for immediate effectiveness, per the requirements of SEC Rule 19b-4(f). The NYSE's response misrepresents my position and demonstrates an ignorance of the intricacies of Rule 19b-4, as well as basic statutory requirements regarding immediate effectivene ss of purported SRO rule interpretations.
Rule 19b-4 does not require the submission to, or approval by, the Commission of SRO rule interpretations that are "reasonably and fairly implied" by the plain text of an existing rule. The reason is obvious: the interpretation is clear from the rule text. The NYSE staff's position that its "longstanding interpretation" is "reasonably and fairly implied" by the text of Rule 108 is laughable (see discussion above). Obviously, the SEC staff disagreed with the NYSE on this, or they would not have insisted that the NYSE go through the rule submission process on this matter.
Rule 19b-4 does permit an SRO to obtain immediate effectiveness of an interpretation that is not reasonably and fairly implied by the text of an existing rule (these are the only types of interpretations required to be submitted), but only if the SRO has "properly designated" the matter as an interpretation. An SRO cannot designate as an "interpretation" material that is inconsistent with, or contradicts, the text of of an existing rule, nor can an SRO designate as an "interpretation" material that in fact effects a substantive change in a rule, or adds substantive requirements. In such instances (clearly the case here), the SRO must undertake to amend rule text pursuant to the Commission's normal prior public comment procedure.
As I noted in earlier correspondence, not only is the NYSE's "longstanding interpretation" not reasonably and fairly implied by the text of Rule 108, it cannot conceivably be so implied. The NYSE is, in fact, proposing a substantial overhaul of Rule 108, and must proceed by formal amendment to the text of that rule, pursuant to the Commission's normal prior public comment procedure.
As the NYSE merely repeats its familiar assertions under this section of its comment letter, I will not dwell at length here. But I will note one absurd observation (page 10): "by the commenter's [ yours truly ] logic, all filings for immediate effectiveness would be either unnecessary or indicative of illegal conduct by the filing exchange." Under Section 19(b) the Securities Exchange Ac and SEC Rule 19b-4, filings for immediate effectiveness are clearly necessary and required when they are "properly designated" as interpretations, but are not reasonably and fairly implied by existing rule text. (As I noted above, an interpretation that is reasonably and fairly implied does not require submission to the SEC, pursuant to the SEC's own rule).
It would, however, obviously be "indicative of illegal conduct by a filing exchange" for an SRO to proceed under an "interpretation" required to be submitted to, and approved by, the Commission (even if it could properly be submitted for immediate effectiveness), prior to acting under the Commission's submission/approval process. Simply put, an SRO is acting illegally if it proceeds under "interpretations" not reasonably and fairly implied by existing rule text before the SRO obtains SEC approval of the "interpretation." I suggest that the NYSE staff obtain the advice of competent counsel on this.
I will restate the obvious: the NYSE is permitting trading practices to occur that in fact require prior (and to date unobtained) SEC approval. The only possible position the Commission can take is that the "longstanding interpretation" cannot conceivably be implied by the text of Rule 108, that the NYSE is in fact proposing a substantial revision to the rule, and that the NYSE must amend the rule text under the normal prior public comment procedure.
And, of course, the SEC must demand that the NYSE cease and desist permitting the illegal trading practices to occur unless and until requisite SEC appro val is obtained.
The NYSE Has Failed to Document its "Longstanding Interpretation"
In my earlier correspondence, I noted that the NYSE had failed to discuss the background, history, and purpose of Rule 108. In response, the NYSE staff have not discussed at all the background of Rule 108, per se, but rather have offered a highly generalised, disjointed "survey" of two early SEC efforts to come to terms with floor trading on the NYSE and other exchanges. The NYSE staff's discussion fails to discuss at all any background documentation with respect to Rule 108 specifically.
In earlier correspondence, I stressed that Rule 108 has historically been interpreted in tandem with the specialist's negative obligation, which prohibits the specialist from effecting proprietary trades "unless such dealings are reasonably necessary to permit such specialist to maintain a fair and orderly mar ket." As I demonstrated specialist parity acquisition trading can never be reconciled with the negative obligation, as there is no "necessity" for the specialist to trade when public orders at the same price can fully absorb incoming contra side liquidity. Astonishingly, the NYSE has made no attempt whatsoever to explain how its "longstanding interpretation" is in any way consistent with the negative obligation. But then again, it would clearly be too much to expect anyone, much less the NYSE staff, to be able to explain the unexplainable. But this is a huge, and unaddressed, problem with the NYSE's "longstanding interpretation."
The NYSE staff could not relate either document they cited specifically to specialist parity acquisition trading, and they ignored the fact that both documents in fact emphasised strict application of the negative obligation. The Segregation Report is one of the conceptual pillars of specialist regulation; its co ntinued relevance today is its uncompromising insistence on emphasising the negative obligation and demanding strict application of the "necessity test" regarding specialist trading. This emphasis on the negative obligation was a key reason why the Segregation Report did not recommend the segregation of the specialist's dealer and broker functions. (I'm sure the SEC staff are familiar with this).
The Report on Floor Trading focused more on activity by brokers rather than specialists, but, as the NYSE itself acknowledged, the Report concluded that specialist dealer activity was permissible so long as "such transactions are reasonably necessary to the maintenance of a fair and orderly market" (the classic formulation of the negative obligation).
The fact that both documents cited by the NYSE emphasised strict application of the negative obligation makes the NYSE's failure to address the issue that much more glaring. Bu t despite citing these two SEC documents, the NYSE staff made no effort whatsoever to relate the content of those reports to the specific considerations at issue regarding Rule 108. Indeed, the singular failure of the NYSE's "historical" discussion is the total absence of any specific discussion of the history of Rule 108 itself.
The NYSE staff simply make a leap from the SEC background documents to an assertion (page 11) that Rule 108 "was not meant to" eliminate specialist parity acquisition trading. The NYSE offered no documentation, from either NYSE or SEC source documents, to support this assertion.
For the NYSE to be acting in good faith here with respect to its claim of a "longstanding interpretation", the NYSE staff would have had to have reviewed documents, dating back decades, reflecting the unique linguistic insights into the meaning of "entitle", the basis/foundation for the purported "longstanding interpretation" of the rule text. But I'm not going to beat a dead horse here. For reasons of plain language, the canon of statutory construction, and the fact that the very "source" documents cited by the NYSE staff emphasised strict application of the negative obligation, it is painfully obvious that no such historical Rule 108 documentation about "entitle" exists. If such documentation did exist, the NYSE staff would have proudly produced it.
We all know what happened here. The NYSE had been permitting parity acquisition trading for any number of years (as it had permitted other practices that led to two SEC enforcement actions) without focusing on the fact that it was specifically forbidden by Rule 108. When embarrassed by their candid and doubtless inadvertent admissions in Amendment 5 of SR-NYSE-2004-05, the NYSE staff scrambled to "justify" the trading practices. Deluding themselves that they could split hairs regarding the mea ning of "entitle", the NYSE staff imagined that they could "project back in time" their bogus linguistic exercise and assert that the drafters of Rule 108 must also have split the same hairs. Thus, a "longstanding interpretation" was born. And why bother the Board of Directors with mere technicalities?
"Bad faith" would be the height of understatement. This is truly disgusting stuff, an absolute insult to the Commission and to the public.
The Floor Broker "Objection Mechanism" Is Obviously Inadequate
In my earlier correspondence, I noted the absurdity of positing a floor broker objection mechanism as a meaningful public protection safeguard. I noted that floor brokers joke openly about the adverse consequences to them and their customers if they do not allow specialists to compete directly with their customers (this is easily verifiable by the SEC staff). I noted the "get along by going alon g" culture of the NYSE trading floor, and observed that the NYSE proposal was obviously being pushed by specialists eager for additional proprietary trading opportunities, the source of most of their profits.
In response, the NYSE staff suggested that I am making "naked" assertions not supported by objective data, and that, in a competitive market, brokers would lose business if they did not object to specialist bullying.
The assertions I made, and continue to make, are anything but "naked." They are rooted in the fact that the SEC had to take two recent enforcement actions against the NYSE for failure to enforce its floor trading rules, surveil its market appropriately, and interpret its rules correctly. With respect to floor brokers, an NYSE member told me recently that the NYSE had to take enforcement action against literally dozens of brokers, far more than reported by the media. These individuals were clearly disadvantaging customers, who, like virtually all customers, are completely in the dark about what actually happens on the trading floor. Did other floor brokers or specialists "blow the whistle" about the illegal behavior? Of course not. "Get along by going along" is, if anything, an understatement.
And what of specialists? Did they not rape the customer Superdot order flow to maximise profits? Were they not fined about a quarter of a billion dollars (across all firms)? And did anyone on the trading floor "blow the whistle" on them? I rest my case.
And what of the NYSE itself? Fined, embarrassed, and its senior regulators about to face SEC sanction, according to a recent Wall Street Journal article.
I take no pleasure in saying this (remembering better days, I actually tend to defend the NYSE to my institutional clients), but, based on recent history, it is hardly an exaggeration t o say that the NYSE trading floor, in certain respects, is a cesspool overseen by incompetent, credulous NYSE staff. Just read the SEC settlement orders. And the NYSE should not underestimate the depth of skepticism and disdain that exists in the institutional trading community as to the ability of the NYSE to regulate its market. There is a reason that the NYSE is losing market share.
Given this recent background, it is shocking that the NYSE would not insist on strict enforcement of rules as written, particularly a "put the public first" rule such as Rule 108. The approach being advocated by the NYSE is not only counter-intuitive, it is meaningless. The NYSE approach would presume that a specialist has the right to compete directly with public orders, and puts the onus entirely on a broker to not only object, but puts a further onus on the broker to document such objections. Imposing new behavioral and recordkeeping requirements on brokers functioning in a "get along by going along" environment virtually assures that brokers will almost never object. Who needs what will be, in fact, a real hassle?
Furthermore, the NYSE approach is unmonitorable and unsurvieillable, because the NYSE will never be able to ascertain when a broker failed to object for "cultural" reasons, and thereby disadvantaged a customer. The notion that this is somehow self-policing because brokers will lose customers is laughable. Customers will never know or understand what actually happens in any given trading situation, and the prospect of losing customer business was hardly a deterrent to the illegal behavior in the two recent trading scandals.
In the pollyanna world of NYSE regulation, a "trust the broker to object" approach might seem like a meaningful customer protection measure. But in the real world, a world of both reality and perception, this just doesn't pass the giggle test.
In the event, the "objection mechanism" is a clear-cut regulatory requirement that is in no way, shape, or form implied by the plain language of Rule 108. It clearly needs to be reflected in rule text and submitted pursuant to the Commission's normal prior public comment process, along with the rest of this sorry mess.
The NYSE Proposal Is Unnecessary
The NYSE contends that its proposal is appropriate because customers want additional volume from other market participants to accompany their own trading volume. In my earlier correspondence, I demonstrated that this is readily accomplished under existing rules by a specialist's "follow trade", a common occurrence in the NYSE's market. Such trades are not effected on parity, and they do not implicate the negative obligation, as the specialist is trading against an unfilled imbalance, left over after floor brokers have traded.
The "follow trade" methodology assures that the specialist is only trading as appropriate, and is not competing directly with public orders. In addition, the "follow trade" methodology provides a much cleaner record for surveillance purposes, as the specialist's dealer activity is isolated in a separate trade.
I provided two simple examples, both of which the NYSE staff take issue with. The NYSE staff contends that I do not understand how the NYSE market works. As with other recent rule submissions (see, e.g., the utter fiasco of the NYSE's correspondence on SR-NYSE-2004-70, in which the NYSE staff had to acknowledge an absolute howler of an error regarding a basic rule), whenever the NYSE staff try to make this point they simply demonstrate the depth of their own ignorance.
I will not repeat the first example as it is fully set out in my November 1, 2005 letter. The essence of the NYSE staff's objection is that the firm quote rule would preclude the result I posited in the first example. The NYSE staff need to take another look at the firm quote rule, as it is not addressed in any way to the actual order execution mechanics in a "receiving market." Rather, the firm quote rule is intended to assure that an "incoming" order gets to trade at the price/size displayed by the "receiving market." (I'm certain the SEC staff understand this). In my example, the 'incoming order (for 1000 shares) receives an execution consistent with the depth of the market being displayed (2000 shares), and at the price being displayed. There is absolutely no conflict whatsoever between my example and the firm quote rule.
Again, I will not repeat the second example. The NYSE staff's objection here is somewhat incoherent, but they seem to be saying that brokers on parity must always split executions equally. NYSE rules certainly suggest an equal split, but (I have confirmed this point with two NYSE floor brokers) unequal splits are quite common, as a broker may choose not to take an entire "fill" he or she is otherwise permitted to obtain.
The NYSE staff also made the following observation:
"His [yours truly ] analysis, moreover, also ignores several possibilities that are positive for the customer, such as the possibility that the specialist is buying into a declining market, and that as a result of his trading on parity, customers A, B, C, and D might complete their purchases at one or more lower prices."
This observation clearly manifests the NYSE staff's naivete and incomprehension of how the NYSE trading process actually works, and what actually motivates a trading decision. The NYSE staff's scenario, is possible, in theory, but relatively unlikely in practice. The exact opposite result is far more likely, to the detriment of the public, but to the benefit of the dealer account.
In a declining market, there are apt to be fewer "buying" parity opportunities, because brokers are more likely to be selling rather than buying. To the extent that brokers are buying, there is a diminished likelihood that the specialist will seek to compete with them. The reason is obvious: the specialist is not "eager" to buy stock in a declining market (although he/she has to if no one else will) because there is real market risk in this situation. As the market continues to decline, the specialist's inventory position will be marked down. Thus, the specialist will be perfectly content to let the brokers trade without competition.
It is in an advancing market that the real problem arises, as even during a gener al upswing there are apt to be numerous "ticks" at which the specialist may trade. This is where the specialist will be most eager to compete with public orders. Again, the reason is obvious: as the price of the stock increases, so does the value of the specialist's inventory position. The effect of the specialist's competition with the public, of course, is that the public orders receive less of a fill on each trade, and wind up paying higher prices as the market continues to advance.
The specialist wins, the public loses.
It really is that simple.
How can the NYSE, with its historic "put the public first" reputation, possibly be advocating this garbage?
The SEC staff justly enjoy a reputation for competetence and integrity. I am certain they understand exactly what the NYSE is up to here, and will act to protect the public interest.