This is the article Steve is referring to...
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March 12, 2001
Big Board Specialists Make Money
Despite Being an Anachronism
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
In a world that dot-coms were about to take over, what could the future hold for a system of stock trading so clunky it relied on human beings? Surely, folks said a couple of years ago, in an electronic age, the "specialists" working the floor of the New York Stock Exchange were dinosaurs.
Dinosaurs should be so hardy.
The obscure functionaries who handle the murky tasks of matching buy and sell orders, keeping markets "orderly" and deciding where to "open" a stock are scoring their biggest profits ever. Profit averaged $16 million per partner in just nine months at one specialist firm last year, Spear Leeds & Kellogg. Wall Street giant Goldman Sachs Group, which had decried the NYSE floor system as a barrier to the market's competitiveness, now is rushing to acquire specialists.
Why the turnabout? Part of it is that electronic networks have failed to reach the critical mass of buyers and sellers needed to be a genuine alternative. But in addition, the specialists themselves have changed. They are increasingly exploiting their unique inside view of the markets to do highly profitable trading with their own money.
Profits and Grumbling
This trend has made them robustly profitable. But it also has triggered much grumbling, about a group that has always inspired mixed feelings.
The main job of specialists, also known as market makers, is simply to match investors' orders to buy stocks with orders to sell them. But what if there are more orders to sell a particular stock than to buy it? Then the specialist firm has to step in with its own money and buy. Or sell, if there's an excess of buy orders.
But the specialist isn't supposed to buy or sell if doing so would interfere with fair and orderly trading.
In return for meeting these obligations, the specialist is allowed near-complete knowledge of how much buying pressure and how much selling pressure there is. It's a privilege that any other market participant would die for.
And it's an easy position to misuse, say the system's critics, who contend that specialists are doing just that more and more in order to fatten their profits. That is what some suggest happened one day last October with Compaq Computer Corp. shares.
Phil Marber, a trader at Cantor Fitzgerald & Co., placed an order to sell 100,000 shares of Compaq for a big institutional client at no less than $24 a share. Minutes later, Mr. Marber saw a 25,000-share trade in Compaq cross the tape -- at $23.99. He called down to his broker on the floor of the New York Stock Exchange to see what happened.
Undercut by a Penny
He was told that a broker who wanted to buy 25,000 shares had entered the crowd, and that the specialist firm handling Compaq stepped in and sold him shares out of the specialist's own account, for one penny less than Cantor's client was willing to sell for.
Mr. Marber says the specialist figured that with a big seller out there at $24, Compaq stock wasn't about to rally, so dumping it at $23.99 would be a good move.
But why didn't the specialist simply match the buy order with the Cantor client's sell order? Isn't a specialist supposed to do its own buying or selling only if there is an imbalance of buyers and sellers?
The specialist was LaBranche & Co. Its chief, Michael LaBranche, says he doesn't know this specific trade or whether his firm in fact sold any of the 25,000 shares. But if it did, he notes, it did the buyer a favor by selling him stock at a slightly lower price than he would otherwise get. He also says $23.99 might have better reflected supply and demand for Compaq at that moment than $24.
Critics call what LaBranche did "stepping in front" or "penny jumping," and think it's an abuse even though within the rules. "Specialists' attention to their own profit and loss risks eroding confidence in what has been a great marketplace," says Kenneth Sheinberg, head of listed-stock trading at S.G. Cowen.
But what the critics call stepping in front, specialists call "price improvement." Notes Big Board Chairman Richard Grasso: "You'll talk to people who say penny-skipping is negative. You'll also talk to people who say a penny better is a penny better."
Whichever it is, it's made easier when stocks trade in tiny increments -- a penny instead of an eighth or a sixteenth -- as all Big Board stocks now do. Specialists say the tiny increments require them to step in more often to keep the market orderly. But even before the NYSE went all-decimal in January, its specialists were doing more buying and selling on their own, known as "principal" trading. NYSE figures show that the portion of Big Board volume in which specialists acted as a buyer or seller, rather than simply a matchmaker, jumped to 27% last year from 18% in 1996.
As this principal trading has risen, so have specialist firms' profits. They soared to an estimated $708 million last year -- the after-tax total for all NYSE specialist firms -- from $201 million in 1996. Specialists' estimated after-tax return on capital jumped to 26% from 17% in that period, far beyond the 10% or so of the NYSE's brokerage-firm members.
This comes just a couple of years after the blaze of excitement over electronic networks like OptiMark Technologies Inc., whose anonymous stock-matching system some thought would make the Big Board's floor system obsolete. In 1999, Mr. LaBranche struggled to take his New York-based specialist firm public and "almost didn't get the thing done because people thought the NYSE specialist would be [displaced] by technology," he says. But OptiMark, whose investors included Merrill Lynch & Co., Goldman Sachs and Dow Jones & Co., publisher of The Wall Street Journal and WSJ.com, failed to make inroads on the NYSE and has closed its stock-trading operation. Meanwhile, LaBranche's stock has risen to almost triple its IPO price.
Big Board specialists traditionally competed against regional stock exchanges and over-the-counter market makers. But in recent years, the biggest threat has come from electronic communications networks, which automatically match buyers with sellers with no specialist or market maker coming in between. ECNs handle a third of Nasdaq trading, and most foreign markets have replaced their floors with ECN-like systems.
Not Here
They have failed to make much of a dent in the NYSE's business. With 84% of trading in its stocks taking place on the Big Board floor, the exchange simply remains the easiest place for buyers and sellers to find each other. It's circular: Institutions don't trade Big Board stocks very much on ECNs because ECNs don't have enough orders -- and ECNs don't have enough orders because institutions don't trade on them very much. As a result, while ECNs can charge less and execute faster, there's a risk they won't be able to execute an order at all or only at an inferior price, Mr. LaBranche notes.
There are subtler factors, too. Some institutions rather like the human factor, the poker-playing feel of dealing in the crowd on the floor. Kevin Cronin, head of domestic-stock trading at AIM Capital Management -- while critical of frequent trading by specialists -- notes that one can ask them for insights into how stocks are trading, but "you can't ask an electronic system questions."
A specialist also can impose order on a chaotic situation. If suddenly flooded with sell or buy orders the specialist can, under some circumstances, ask that trading be halted until everyone has a chance to absorb the news that caused it. Specialists say they probably wouldn't have let Axcelis Technologies Inc. shares shoot from $10 to as high as $93 because of an investor's typographical error, as happened last month on the Nasdaq Stock Market, where stocks aren't handled by a single person with a full grasp of supply and demand but by ECNs and many different market makers.
Some Wall Street giants that have invested in ECNs and argued that the NYSE should drop specialists or curtail their role now have muted their rhetoric. Goldman, once the loudest proponent of replacing the whole NYSE floor with an electronic network, spent $6.5 billion last year to buy Spear Leeds. Though the specialist business was less of an attraction than Spear Leeds's Nasdaq, options and trade-processing businesses, Goldman has since agreed to buy another specialist firm, Benjamin Jacobson & Sons.
FleetBoston Financial Corp., which already owned a specialist firm, acquired another one late last year. And Bear Stearns Cos., also already in the business, has just moved to buy another specialist firm with its partner, Hunter Partners LLC.
Squeezing Together
These deals cap a consolidation wave and a culture shift. The specialist system dates back to the late 1800s, when floor brokers began leaving orders with other brokers who would specialize in a particular stock. Legend has it that the first specialist was a member with a broken leg who planted himself at one spot on the floor, according to the NYSE's illustrated history of its first 200 years.
Fifteen years ago there were still 54 specialist firms, mostly small family-run firms getting at least half of their profits from commissions for matching buyers and sellers. Since then, specialist commissions on some orders have been eliminated as the Big Board has tried to remain competitive. And when the latest mergers close, nine-tenths of the Big Board's volume will be controlled by just five specialist firms, which will typically obtain some 80% of their profits from their own buying and selling of stocks. The five are LaBranche, the Spear Leeds unit of Goldman, the Fleet Meehan Specialist unit of FleetBoston, a firm to be known as Wagner Stott Bear Specialists, and Dutch-owned Van der Moolen Specialists USA.
Specialists' principal trading, as opposed to mere order-matching, has always been controversial. The Securities and Exchange Commission considered trying to ban it in the 1930s but gave up in the face of fierce NYSE resistance, writes market historian Robert Sobel.
Criticism of specialists sometimes is no more than routine Wall Street griping when one party isn't happy with how a trade turned out. Part of it just reflects growing competition between "downstairs" specialists and "upstairs" Wall Street traders.
While complaints are nothing new, they appear to be more frequent. Recently, the NYSE has stepped up its discipline of specialist firms. After disciplining such firms only 13 times in the 10 years through 1998, it has sanctioned specialists 14 times in the past two years for failing in some way to carry out their obligations to maintain fair and orderly markets.
Those obligations carry risks, because a specialist may be the only buyer when a stock is headed straight down or the only seller when it's headed straight up. LaBranche frequently had to step in and buy AT&T Corp. and Lucent Technologies Inc. shares as they plunged in the third quarter last year, and it lost millions doing so.
Among the most controversial incidents are big moves at the open or close of trading. One morning in October, after International Business Machines Corp. had reported weak sales growth, sell orders were pouring in and gloom pervaded the market. Some 50 brokers crowded around the two IBM specialists from Spear Leeds. After half an hour of collecting orders, Spear Leeds's Bryant Yunker Jr. issued a price "indication" a few minutes before the opening bell. He said IBM would probably open at between $95 and $98 a share, far below the prior day's close of $113 but about where the stock was already changing hands on an ECN operated by Instinet Corp.
But with more sell orders arriving and brokers changing their orders, Mr. Yunker warned that this price indication wouldn't hold, and issued a new one: $92 to $96. Then a broker ran into the crowd yelling to hold the opening -- he had a big block to sell. The indicated range dropped to $90 to $94.
Finally, at 9:45 a.m., the opening trade hit the tape: four million shares at $90.25, down a whopping $22.75 from the previous day's close. That sliced 135 points from the Dow Jones Industrial Average, of which IBM is a part, widening the DJIA's loss at the time to about 425 points. The market was in freefall.
Had IBM kept dropping, few would have suffered more than Spear Leeds. With more sellers than buyers around, the specialist had to purchase almost 500,000 shares at the opening, say traders present that morning. But within 10 minutes, IBM was back up to $95, handing Spear Leeds a profit that outsiders estimate at as high as $1 million.
Grumbling followed swiftly. Since Spear Leeds had opened IBM sharply below where the stock was trading on Instinet (and where it was just 10 minutes later), it appeared the specialist "might have forced [it] down an extra couple of points," says S.G. Cowen's Mr. Sheinberg. The lower price -- which was also the price at which Spear Leeds did its buying -- meant bigger profits for Spear Leeds when the stock rebounded.
Spear Leeds co-chief Andrew Cader says the opening was a "reasonable representation of what a specialist can and should do on a day when the entire market was falling out of bed." Mr. Sheinberg agrees that second-guessing is easy and managing an opening under such conditions is not.
Mr. Grasso has steered a middle course amid controversy over specialists, who own or lease a third of the Big Board's seats and hold three of the 24 directors' spots on its board. When ECNs were on the rise in 1999 and the Big Board chairman faced pressure from large firms to adopt screen-based trading, he arranged for a board committee to look at the market's structure. It came back with a report trumpeting the importance of the specialist, especially in "moderating the severity of market volatility." Mr. Grasso also began a pilot program that lets investors bypass specialists with small orders. But he maintains specialists' trading has been "enormously positive" to the Big Board's customers and he has shown no inclination to materially reduce their role on the NYSE.
It's fine with Mr. Cronin of AIM Capital, who likes "a centralized marketplace where we can find buyers and sellers and can find anonymity on the floor." But Mr. Cronin adds: "If specialists continue this egregious behavior of stepping in front, blocking trades and dislocating openings . . . , maybe the things people have predicted for so long about the system will come to fruition."
