April 18, 2006
It seems odd that the NYSE would propose a significant reduction in the required capital of its seven specialist firms at the same time volume on the Exchange has exploded, and radical structural changes in the market are ongoing.
The NYSE now owns two competing market structures, Archipelago, which is fully automated, and the existing floor-based manual system, currently being augmented with what is called by the NYSE a "Hybrid System."
NYSE Group's most recent S-1 filing with the Commission (April 14, 2006) lists among many others, the following "Risk Factors:"
"The successful implementation and operation of the NYSE Hybrid Market℠ faces a number of significant challenges and depends on a number of factors that will be outside our control.
We are currently working on implementing the NYSE Hybrid Market℠ , which was approved by the SEC on March 22, 2006. The NYSE Hybrid Market℠ is intended to integrate into one platform aspects of both the physically-convened auction market and automated electronic execution. This effort is our response to the request from both market professionals and individual investors for greater choice and flexibility in buying and selling stocks on the NYSE. The NYSE Hybrid Market℠ is also our strategy for adapting to the revised "trade through" rule adopted by the SEC on April 6, 2005 as a part of Regulation NMS, which prohibits trading-through quotations that are displayed by another market and immediately accessible through automatic execution. If successfully implemented, we expect that the NYSE Hybrid Market℠ will change the way that securities are traded on the NYSE and will differentiate the NYSE from electronic trading venues. This initiative is being launched in phases during 2006.
In December 2005, the NYSE initiated the first phase of the NYSE Hybrid Market℠ as a pilot to test selected features and functionality among a limited number of securities approved by the SEC. The pilot terminated upon SEC approval of the NYSE Hybrid Market℠ initiative and floor-wide roll-out of the first phase began. As of April 5, 2006, the first phase of the NYSE Hybrid Market℠ has been implemented in substantially all securities listed on the NYSE. To date, NYSE Hybrid Market℠ software is functioning as expected, and all implemented features are being actively exercised by trading floor professionals. However, technological, functional, or other problems with respect to NYSE Hybrid Market℠ may not come to light until additional features and functionality are introduced through subsequent pilot phases over the next several months.
The successful implementation of the NYSE Hybrid Market℠ faces a number of significant challenges, including the difficulties of developing and implementing novel technology and the ability and willingness of specialists to build new technology platforms. In addition, as a novel technology and method of trading, there is no assurance that the NYSE Hybrid Market℠ will function as it is currently anticipated to function, or that customers will accept and use the services that it offers. The operation of the NYSE Hybrid Market℠ also places greater demands on NYSE Regulation, and specifically market surveillance.
Any delay or difficulties in implementing or operating the NYSE Hybrid Market℠ may have a material adverse effect on our ability to compete and our operating results, particularly if the NYSE Hybrid Market℠ is not implemented by the time that the first phase of Regulation NMS goes into effect. Currently, the first phase of Regulation NMS is scheduled to go in effect on June 29, 2006. Although the NYSE expects that it will be able to be in compliance with Regulation NMS by June 29, 2006, it expects that it will not be able to implement all of the planned features and functionalities of the NYSE Hybrid MarketSM on the effective date of this first phase unless the SEC postpones this date. In addition, any unwillingness by our customers to accept or use the NYSE Hybrid Market℠ services may also have an adverse impact on our ability to compete and on our operating results. For a discussion of the NYSE Hybrid MarketSM, see "BusinessInformation About the NYSEThe NYSE Hybrid Market Initiative."
"Certain of our businesses rely on specialists for effecting some transactions. Any failure by specialists to perform their function effectively or to comply with their regulatory obligations may have a material adverse effect on our business.
Specialists are an important component of the market structure within the NYSE. For example, specialists assist in providing liquidity and minimizing volatility. A deterioration in the performance of specialists, or misconduct by specialists, could damage our reputation and reduce our ability to compete with other securities exchanges for listings and order flow. The profitability of the seven specialist units currently active on the NYSE has fluctuated significantly since 2002.
The increased use of technology (and, in particular, computers) in securities executions also is changing the business models of specialists. Their failure to adapt their business models to this changing environment in general, and to the NYSE Hybrid Market℠ in particular, would further undermine the differentiation, and therefore the competitive position, of NYSE Market. For a discussion of certain litigation and SEC action relating to specialists, see "BusinessProceedingsIn re NYSE Specialists Securities Litigation."
We derive significant revenues from activities related to our trading floor, including trading fees, facility and equipment fees and trading license fees. The migration of trading volume away from the trading floor and into our or others' electronic trading platforms could adversely affect these revenues."
Given NYSE Group's own stated concerns about the new trading system as well as concerns about the viability of their specialist system would make this a very inauspicious time to reduce their capital requirements.
The Commission should, at the very least, defer approval of this proposal until the success of the Hybrid market has been assured.
Very truly yours,
Junius W. Peake
Monfort Distinguished Professor of Finance
Kenneth W. Monfort College of Business
University of Northern Colorado