Failing Grades at the NYSE
Ananth Madhavan, a noted market structure scholar and managing director of ITG, recently told the New York Times that the NYSE âis sort of an historical accident.â Consistent with an emerging array of data, he suggested that a redesign of the NYSE âwould not start with a floorâ¦you would do it electronically.â
Richard Grasso, NYSE Chairman, responded in the same article that âblending human and technology in terms of providing services to customers, thatâs what this is all about.â
The SEC attempted to resolve this apparent conflict between two powerful and competing viewpoints through adoption of Rule 11Ac1-5 last year. This rule compelled market centers to report monthly statistics that measure execution quality for small-order customers. In key measures of effective spread and speed of execution, the first monthâs data indicated relatively poor NYSE performance. The exchange attributed the results to the dataâs exclusion of institutional âblocks,â in one report.
This defense constituted a surprising irony. The NYSE traditionally relied on the promise of âprice improvementâ for âhouse painters and school bus driversâ as the pretext for internal rules and policies. Institutions long have complained that many of those policies undermined the primacy of limit orders on the exchangeâs own book and the interests of the other âlittle guysâ invested in the nationâs mutual funds.
Mounting evidence implies that intermediation imposed on customers of the NYSE carries high costs and perhaps illusory benefits. Moreover, its physical structure represents a visible âsingle point of failureâ in our financial system.
Order Display Rules in Listed Stocks...Unfinished Business
Thus far, exchanges and ECNs have forestalled the extension of the Order Handling Rules (OHR) to the trading of listed stocks. Regulators cite the access fee conundrum as impeding âunfinished businessâ that would drive ECN listed order flow into the public quote.
Only Archipelago ECN now displays its listed orders in the NBBO through the ITS-CAES link offered by NASDAQ. Archipelagoâs business decision to comply with the display rules extended a powerful additional tool to traders. Our traders realized trade cost savings of $9.4 million on $1 billion of listed Archipelago trades in the yearâs first half and more than $220 million in eleven non-traditional venues over 18 months.
Despite Archipelagoâs demonstrated efficacy, our traders express growing frustration at the interplay between ECN orders and exchange floors. Those frustrations echo the charges of âbacking awayâ and âtrade-throughsâ that formerly dogged NASDAQ market makers.
Trade-Throughs
Archipelagoâs decision to actively seek âbest priceâ through ITS-linkage once again illuminated the problem of frequent apparent âtrade-throughsâ at both the NYSE and AMEX exchanges. A trade-through occurs when one âlinkedâ market trades at an inferior price to another marketâs price as reflected in the NBBO. Markets must respect or satisfy better prices available in competing markets as a condition of ITS participation.
The frequency of complaints about specialist handling of our orders, and complaints from other similarly confounded customers, prompted Archipelago to create a new audit trail for customers. Dubbed âwhinerâ software, Archipelago examined the conditions that generated many inquiries and then automated complaints to the exchange if three conditions exist:
· The order in the public quote is more than 100 shares;
· the order appears on the ARCA book (and in the NBBO), 15 seconds before a âregular wayâ print at the inferior price is published;
· and remains on the ARCA book (and as part of the NBBO) for 10 seconds after the inferior priced trade is reported.
The âwhinerâ software documented the following:
· A total of 201 366 individual securities recorded more than 20 complaints within a single day during 53 69 trading sessions from June 18 through August 31 October 4, 2001; NYSE complaints frequently exceed 1,000 a day for stocks traded on Archipelago.
· Nine Twenty securities generated more than 20 complaints in a day at least five times during the period. IBM exceeded 20 complaints on 18 25 days. AOL, C, MER and PFE on 11 days; MWD on eight nine days and MER on seven days. and JPM on eight days.
· Complaints for many stocks reach high double digits on any given day. KRB generated 90 trade-through complaints on June 27; MEL, 73 on August 9; PFE, 73 on September 5; IBM, 69 on October 3; MER, 68 on June 18; GSB, 68 on August 28; MER, 66 on June 27; KRB, 62 on June 25 and IBM, 60 on August 1.
One can infer only two possible explanations for this empirical data. Specialists either ignore obligations to satisfy the best price across all markets linked by ITS, or the human brain cannot keep pace with the trading demands of both an active crowd and electronic markets. Specialists have limited bandwidth and may make frequent mistakes, as did the specialists in KRB, IBM and MER.
Our experience regarding handling of listed orders at the specialist post has changed little over the years. We call the Institutional Hotline for redress. They promise to investigate and report back to us. Most often, we receive assurances that such trade-throughs were permissible under NYSE rules. On infrequent occasions, we merit price adjustments. Alternatively, officials report that âthe specialist is swamped, he missed your order,â and sometimes that the trade required more than 15 seconds to post to the tape.
Specialists Can Freeze the Book
Some traditional brokers report increasing use by specialists of a practice known as âfreezing the book.â The specialist declares an âunstable marketâ and refuses electronically delivered orders (DOT) until the market resolves, usually with a minor price adjustment. Such conditions need not be published nor announced. These trading âhiccupsâ reportedly occur in major listed stocks six or seven times a day. The âfreezeâ effectively protects the crowdâs order queue as if the electronic order did not exist.
We worry that specialists increasingly behave as market makers did prior to imposition of the Order Handling Rules. The SEC may be required to act yet again to enforce principles of best execution. Self-regulated markets seldom embrace âintrudersâ who threaten dominant market control. We hope that over time the data may yield more comfort that human intermediation creates quantifiable value for investors. In the meantime, the arguments put forth by Ananth Madhaven appear difficult to refute.
hsb
