April 12, 2006

Dear SEC:

The NYSE's letter of March 31, 2006 can only be described as an act of hubris. Rather than respond to my very detailed critique of its proposed drastic reduction in specialist capital requirements, the NYSE merely made conclusory assertions about the adequacy of its proposal. Further, the NYSE merely re-submitted, as an attachment, the exact same material that was critiqued at length in my March 7, 2006 letter. The failure/inability of the NYSE to seriously join issue on a matter of such critical importance is truly shocking.

The NYSE's position is simple: specialist organisations are over-capitalised, and the depth and liquidity of today's markets, and the availability of sophisticated hedging/risk management tools are such that specialist organisations even under the drastically reduced capital requirements can easily withstand a market decline of as much as 30 percent. (The 1987 crash represented a decline of about 22 percent on October 19, 1987). The NYSE claims that the drastic reduction in specialist capital requirements is appropriate in light of the consolidation of specialist organisations and the NYSE's experience with respect to the evolving market conditions in which specialists operate.

As I have commented previously, the NYSE's rule submission appears to have been prepared by its net capital rule staff, who demonstrate no familiarity with either the conditions that led to capital requirements being set at their current levels, or the manner in which stocks actually trade, particularly during crash markets.

The NYSE notes that the SEC received only one comment letter on its proposal (mine). As I have previously noted, the absence of material information in the NYSE submission virtually precluded meaningful comment, as the NYSE nowhere indicated that it was proposing a huge reduction in specialist capital requirements, and nowhere discussed its proposal in terms of minimising risk of systemic failure, a critical consideration in the Specialist Combination Review Policy. Shockingly, the NYSE entirely ignores this point, which was of crucial significance in setting capital requirements at their current level.

The Consolidation of Specialist Organisations

In pre-crash 1987, the NYSE had approximately 55 specialist organisations; today there are only 7. In pre-crash 1987, specialist net liquid assets exceeded average daily trading volume by a ratio of greater than 5 to 1. Following the crash, even with that pre-existing ratio, specialist capital requirements were perceived as seriously inadequate, and were raised.

As specialist organisations began consolidating, both the NYSE and the SEC were concerned about the concentration of financial risk in the ever-shrinking universe of NYSE specialist organisations. This concern arises because of the NYSE's monopolistic, unitary market making system, and the fact that NYSE specialist organisations, in effect, self-insure each other against financial failure. There is no system-wide reserve fund. If a specialist organisation fails under severe stress, its stocks are simply re-assigned to the "surviving" specialist organisations, who will be under severe stress themselves.

The SEC's releases on the NYSE's Specialist Combination Policy make clear that consolidation of specialist organisations demands increased, rather than decreased, levels of specialist capitalisation because of the risk of catastrophic failure of the NYSE market making system when the market making function is concentrated in only a handful of organisations.

The problem, in reality, is the exact opposite of what the NYSE is positing. The SEC and NYSE last raised specialist capital requirements more than 10 years ago, when average daily trading volume was less than one-third of what it is today. Clearly, any revision of specialist capital requirements must be upward, rather than downward.

The NYSE's proposed drastic reduction in specialist capital requirements would result in the NYSE specialist system having mandated net liquid assets of only $1.1 billion, only slightly more than the $800 million universally perceived as grossly inadequate in 1987. And this for a market with more than 12 times the average daily trading volume of pre-crash 1987. (The "mandated" figure is the only one that is really material. Additional capital may or may not be available at crunch time, but investors can hardly be expected to rely on a "check is in the mail" approach to maintaining the financial viability of the NYSE market making system).

The NYSE's "Experience" with Evolving Market Conditions

As I have commented previously, the NYSE's position that its study of normal declines is a predictor of demands on specialist capital during a crash market is a major intellectual embarrassment for the NYSE. (See detailed analysis on this point in my March 7, 2006 letter).

The "depth and liquidity" of the market are, of course, a two-edged sword for specialists. In "calm seas/normal decline" markets, depth and liquidity provide a buffer for the generally low risk/high reward intra-day flip trading by which specialists "make markets." In such markets, it is easy to be seduced by the notion that specialists are over-capitalised, because traditional "intra-day flipping, end the day flat" trading is simply not that risky.

But as the 1987 crash clearly demonstrates, "depth and liquidity" in a crash market are vastly different, as the market becomes largely "one way", and the specialist must respond under the affirmative obligation. In a crash market, depth and liquidity are a shock wave, not a buffer.

The NYSE's actual experience in 1987 (which is the "experience" the NYSE should be focusing on, but is not) amply demonstrates the absolute fallacy of its "study" of normal market declines. In 1987, a 22 percent decline devastated specialist capital, which puts the lie to the notion in its "study" that the specialist system could easily weather a straight 30 percent decline. As the NYSE's own figures demonstrate, NYSE specialists lost $2 in buying power for every share of stock that traded on October 19, 1987, a result in no way comparable to the relatively benign (and indeed occasionally profitable!) impact on specialist capital during a normal market decline.

The NYSE simply refuses to acknowledge what is obvious to any market professional: a crash market is inherently different from a normal market decline.

But what of sophisticated risk offset techniques? Do they not obviate the need for high levels of specialist capitalisation? Hardly, and this is where the NYSE proposal is so naive as to be absolutely dangerous.

In pre-crash 1987, one heard much the same nonsense about depth, liquidity, and the availability of a range of hedging tools, including an apparently promising concept called "portfolio insurance." But the crash was a bucket of cold water to the face as to the absolute viability of such notions. Risk offsets are premised on predictable behaviours and the maintenance of stable trading/pricing relationships between/among financial instruments. In a crash market, as demonstrated in 1987, behaviours become unpredictable, and trading/pricing relationships cannot be maintained, because most market participants want to do one thing, and one thing only, and that's bail out. No one will "offset" risk (at anything near prices that are economically feasible) until the "dust settles." But the specialist must soldier on under the affirmative obligation, one of the great glories of the U.S. market.

I am not talking abstract theory here. This is what happened in 1987, and I urge the current SEC staff to review the SEC's brilliant study of the 1987 crash. And the history of markets is that they do indeed crash periodically, and that hedging tools are irrelevant in the face of "event risk" (the likely trigger of crash markets), as those of us with clients who lived through the Long-Term Capital Management debacle can readily attest.

The NYSE proposal is so wrongheaded, so absolutely at odds with the SEC's and NYSE's own prior, consistent post-1987 crash approach and philosophy, that one can only surmise that the NYSE specialist community has sent credulous NYSE net capital rule staff on a classic "fool's errand" here.

In my last letter, I compared specialist capitalisation to the pre-Katrina levee system in New Orleans, an analogy I continue to believe is entirely apt. The levee system appeared more than adequate under most conditions, and specialist capital is more than adequate under most conditions.

But, as I demonstrated in prior correspondence, the NYSE specialist capitalisation levels today are actually far weaker, in relative terms, than the universally-disparaged levels of pre-crash 1987.

The Commission is on clear, formal notice here, and should it approve the NYSE proposal, will be heavily complicit in the likely event of the financial failure of the NYSE specialist system in a crash market.

(I will not re-submit my earlier correspondence, but ask that it be incorporated by reference herein).

Sincerely yours,

George Rutherfurd
Consultant (to two institutional trading organisations)
Chicago, IL