October 26, 2006
In light of the NYSE's October 25, 2006 amendment of the above-referenced matter, I am writing to supplement my October 20, 2006 letter on this topic. I wish to make the following points:
- The combination of the de facto elimination of the negative obligation and stabilisation requirements on one hand, and the granting to the specialist of an exclusive algorithmic "franchise" on the other, transforms the specialist from an individual who played a limited market making role only when "necessary" (as reflected in reasonably low dealer participation rates and high rates of direct public order interaction)into an aggressive proprietary trader, not really a market maker as that term has been historically understood on the NYSE. And monopoly privilege is compounded here: not only is the specialist the monopoly, ostensible "market maker", but the specialist, through the exclusive algorithm, is being given monopoly proprietary trading privileges largely unrelated to the specialist's historic, limited market making role. This is an anti-competitive burden on competition per se, and the Commission needs to deal decisively with this.
- The Commission needs to address the issue of specialist displacement of public orders, which will only be exacerbated by the NYSE's proposals. In essence, the specialist will be permitted to trade freely, unconstrained by whether any particular trade is "necessary" or not, and largely regardless of the impact of that trade on the market's price direction (no more stabilisation, formerly a key specialist role). In other words, the specialist is simply a uniquely privileged proprietary trader, not a market maker. The public is displaced in two significant ways. First, the public is not permitted to engage in algorithmic trading, which severely limits the public's ability to interact with incoming order flow, to the entire, exclusive benefit of the specialist. In the physical auction, the specialist had to expose all orders, and could only trade if no one else would. If the NYSE were really "replicating" the auction, as it contends it is doing, it would make algorithmic trading available to all market participants, with the specialist's algorithm trading only when no one else's would.
Specialist "parity" (go along) trading directly displaces public orders, and is a flat-out violation of both the negative obligation and Section 11A of the
1934 Act. And while the NYSE's stabilisation proposals are entirely objectionable, the notion that specialists may freely trade in the NYSE's busiest stocks is particularly outrageous. Less specialist participation is needed here, not more, as reflected in the NYSE's own historic TTV rates, and the NYSE's proposals can only result in needless intervention in public order execution, and interference with public investor trading strategies.
- All projections are that overall NYSE trading volume will increase dramatically in the "hybrid" market, with a corresponding significant increase in the need for dealer trading even under current rules. In other words, the financial prospects for the specialist community are favorable (though they'll obviously need fewer individual specialists), and the specialist community hardly needs the "stacked deck" the NYSE (doubtless under specialist pressure)seems hell-bent on giving them. The fact that specialist profitability rates have declined somewhat as electronic trading proliferates is hardly surprising, and is an entirely healthy development. It merely reflects the wringing out of the market of "excess" specialist profit as efficient electronic trading obviates the need for artificial dealer intervention. This quite clearly benefits the public, who, in the zero sum game of trading, have been subsidising the specialists for years out of all proportion to the actual need for specialist intervention. In the event, the specialist business continues to be a profitable one, with a reasonably healthy financial forecast as specialists adapt to new realities. The Commission's task, as always, is to maximise direct public order interaction, not provide a financial windfall to the NYSE specialist community.
- It is appalling that the NYSE staff are proceeding under delegated authority to dismantle a longstanding regulatory schematic which is, in fact, the fundamental tenet of specialist regulation, the negative obligation and its associated stabilisation requirements. It will be a sure sign that something is fundamentally broken with respect to the regulation of the U.S. securities markets if the SEC staff similarly proceeds under delegated authority here, and effectively neuters SEC Rule 11b-1. At a bare minimum, this matter needs to be properly addressed, and placed in appropriate historical context, by NYSE Regulation's Board of Directors. And (if not inclined to dismiss this out of hand, as it should) the Commission needs to solicit public comment on what is, de facto, a major, substantive revision of Rule 11b-1. This is a matter that must be treated at an open, public meeting.
- The sheer intellectual laziness of the NYSE staff continues to astound. The negative obligation, the key specialist regulation intended to ensure maximum public order interaction without dealer intervention, is treated as a mere administrative inconvenience. The NYSE merely repeats the superficial, substantively inadequate "discussion" of this matter in 2006-82, and cannot even be bothered to discuss the actual text of the negative obligation (Rule 104, Rule 104.10(1), and the stabilisation requirements in the context of the negative obligation), or the text Of Rule 11b-1 and the considerations of the Saperstein interpretation, even though these latter two matters were specifically discussed by the SEC staff in the "temporary" 2006-82 approval order. By any measure, SR-NYSE-2006-76 is a particularly shoddy piece of work.
- Proceeding by means of an "interpretation" is particularly ludicrous, as the proposed "interpretation" is inconsistent with the plain language of the negative obligation and cannot in any sense familiar to those who speak English be reasonably derived from that language. In essence, the negative obligation precludes specialist dealer intervention against public order execution unless reasonably "necessary" to minimise a temporary disparity between supply and demand. The determination of such necessity can only be made in the context of a particular trade, which is the way the negative obligation (with good reason) has always been applied. At a bare minimum ( and, again, assuming the Commission simply does not reject this nonsense out of hand) the NYSE needs to propose an amendment to the text of the applicable provisions of Rule 104, and the Commission needs to propose an amendment to Rule 11b-1.
- The NYSE's "pattern or practice" test is a de facto rescission of the negative obligation, as specialists will, in essence, be able to trade regardless of the actual necessity of any individual trade. And the NYSE well knows that a "pattern or practice" test to surveil for violations of the negative obligation is meaningless. Specialists historically have not engaged in trading that caused or exacerbated "excess" market volatility. The NYSE, to the best of my research and discussions with specialists, has never brought a regulatory action alleging such a violation of the negative obligation (see my October 20, 2006 letter for a discussion of how specialists actually trade, and why "excess" volatility has always involved too little specialist trading under the affirmative obligation, not too much trading under the negative obligation). To suggest that a "pattern or practice" test is a viable means of enforcing the negative obligation is to throw words down on paper without regard for fact, law, logic, or actual historical experience.
- Except for presenting an out-of-context excerpt from legislative history concerning the 1975 Amendments to the 1934 Act, the NYSE has made no effort to justify what can only be described as a radical dismantling of a fundamental investor protection. And, as demonstrated in my October 20, 2006 letter the two factors cited in the 1975 excerpt not only do not support the NYSE's position, they contradict it. The "competition factor" actually works against the NYSE, because the NYSE's competitive position and dealer trading rates were far more adverse in 1975 than they are today, yet even in 1975 the Commission saw no reason to modify the negative obligation.
The second factor, elimination of specialist trading privileges, is absurd. In "hybrid", thanks to the exclusive algorithm, specialists are actually being given unique trading privileges far in excess of anything they ever enjoyed in the physical auction. And the "fishbowl" environment of the physical auction, which largely constrained the specialist, is entirely absent in the "hybrid" market.
The Commission must assert the public interest here, and insist that the existing specialist regulatory framework be maintained.
Consultant (to two institutional trading organisations)