Here is a partial quote of today's WSJ editorial
_____________________________________
Penny Wise at the NYSE
Dismal Science
By SUSAN LEE
The New York Stock Exchange is an electronic wonder of sorts, processing around 1.4 billion shares every day. Yet at the center of all these pulses stands the humble human in the form of specialists and floor brokers, charged with the task of keeping capitalism oiled and humming. Techno-capitalism married to human agility and responsibility? Well, it depends on one's perspective. Traders, for example, who are trying to manage investor portfolios with a few keystrokes, think the humble human introduces the possibility of self-dealing.
Consider the current dispute between traders and the NYSE over a practice called penny jumping. Instead of letting investors sell and buy from each other without interference, specialists insert their own trades between investors, improving the price for some investors while making a profit for themselves. The price improvement is possible because of hidden liquidity on the floor -- quotes do not reveal the interest of the crowd.
Some might question the fairness of letting specialists and floor brokers make essentially riskless profits at the expense of public investors, but there is also a more immediate problem. Some investors' orders are left hanging. If the bid on Company X is at 30 and the offer at 31, and the specialist steps in to sell for 30.90, then the buyer has saved 10 cents. But the investor with a limit order to sell at 31 doesn't get her trade executed. She is left to watch helplessly as the price on her screen moves against her, knowing that trying to cancel and change her order would take too long.
Penny jumping can be anywhere from annoying to enraging for traders. But it is just a small part of the conflict between investors and the NYSE. Although price is given priority, time is not. Specialists, and the orders on their books, and floor brokers hanging around the specialists' posts, are all equal when it comes to time. Thus an investor's order may be first in time in the book, but may still not be executed if floor brokers, or the specialist himself, want to trade. Since the floor is able to jump ahead of electronically delivered limit orders, the best one can say about execution is that there is a reasonable probability of a limit order being executed within a reasonable amount of time.
Time is so crucial because orders contain information about where the price will be in the future. A big sell order, for example, can indicate that there's been a bad-news change in a company's prospects. Any delay in the execution of an order allows time for the information it carries to suffuse the floor so the floor can profit. Benn Steil, an economist at the Council on Foreign Relations, says: "Limit orders carry important information, so a delay in execution starts the process by which the price moves." In fact, many observers, as well as burned traders, argue that the best price rule is too narrow. Speed and certainty of execution are at least as important.
Remedies to complaints are often blocked by the fact that the owners of the exchange are the intermediaries who make money from the investors who trade through the exchange. Worse, this inherent conflict of interest between owners and investors often leads to scandalous practices. In its 210-year history, the NYSE has lumbered from scandal to scandal -- making the technical fixes to put out one bonfire only to find a fire blazing away somewhere else. Although the exchange is self-regulating, Congress and the SEC have oversight, so rules multiply. And rules aimed at fixing the NYSE's auction market then make it difficult for alternative venues, like truly electronic networks, to prosper.
It is however possible, within the technical capacity and the regulatory constraints, to make one nifty fix. More orders could be executed automatically. The more automatic execution, the less human discretion with its attendant frailties driven by greed or incompetence.
Currently, small limit orders -- under 1,099 shares -- can be automatically executed under a system called Direct Plus or NX. These orders can be sent automatically into this program or routed there by specialists. The speed and certainty offered by NX is good enough to generate trading interest for large orders that are broken up to stay under the 1,099 limit. (There is, of course, a problem in breaking up orders; it generates waves of buying -- or selling -- and tends to move the price away from the investor.)
Since the technology on NX is also good enough to handle unlimited orders, the NYSE could just declare itself open for all-sized trades on this system. If the thought of unlimited size is too scary, there are useful, more modest alternatives. For example, the exchange could pick a midpoint between its average range of 20,000 to 40,000 shares, and declare automatic execution for orders of 30,000 shares. If that's still too scary for the exchange floor, perhaps the limit could be set at 10,000 shares, the typical size of an institutional order. (The NYSE is about to debut a pilot program especially designed for large institutional traders.)
Of course, what terrifies the NYSE floor brokers (who are also owners of the exchange, remember) is that the ability to penny-jump or front-run will vanish with automatic execution or -- really terrifying -- that there will be no need for humans at all. Investors would be better off without the former and, as for the latter, even with automatic execution there might still be a need to have specialists to smooth the market by doing proprietary trading.
edited
Ms. Lee is a member of the Journal's editorial board.
