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Will the NYSE’s Specialist Probe Open the Listed Market to ECNs?

An investigation by the New York Stock Exchange (NYSE) into trading practices by specialist firms has ignited a firestorm of criticism against the exchange from institutional traders.

An investigation by the New York Stock Exchange (NYSE) into trading practices by specialist firms has ignited a firestorm of criticism against the exchange from institutional traders. Disenchanted with practices such as penny-jumping, as well as specialists stepping in front of their orders for the purpose of price improvement, buy-side traders are clamoring for reforms such as more opportunities for automated execution.

"We think the remedy to this is not more human intervention, it's for more technology that allows buyers and sellers to meet in a non-intermediated, auto-execution mode to eliminate the opportunities for impropriety as they currently exist," says John Wheeler, manager of equity trading at American Century, a Kansas City-based mutual-fund company. Wheeler contends that the system is rigged in favor of the exchange members and floor brokers, and that "investors are being fleeced."

A call requesting comment from the NYSE for this story was not returned by press time.

Institutions are even questioning the value of price improvement - the basic tenet of the Big Board's auction model - which is the idea that buyers and sellers can obtain a better price by exposing their orders to the crowd.

"What the institutional community has come around to realize is that the price-improvement mechanism occasionally improves you by only a penny and, many times, compromises you by six or seven cents or even 20 cents, and sometimes even more than that," says Wheeler.

But the NYSE's problems seem to go further than a few lost pennies. Information leakage and the fear that intermediaries are manipulating the quotes has led some professionals to distrust the floor-based system altogether.

For the Big Board - which trades 1.5 billion shares a day and has 80 percent market share in its own listed-trading volume - these accusations come at a time when several market-structure issues are up for debate.

"You can't look at this in a vacuum," says Bernard Madoff, chairman of Bernard L. Madoff Investment Securities LLC, a market-making firm. "There are lots of market-structure issues that have never been completely addressed like (ECN)-access fees, like making ITS (Intermarket Trading System) operate more efficiently, like changing the ITS governance and also there are the issues of trade-through rules, as well as getting an automatic execution. They're all interrelated, and they all play an important role in how a market maker or a specialist does his job," says Madoff. He declined to comment as to whether or not there was a problem on the NYSE floor, saying it would be unfair since the NYSE is still investigating.

Apart from the investigation, all eyes are still on listed trading.

"You're seeing new competition on the block," says Miranda Mizen, senior analyst with TowerGroup, who cites the rise of new alternative-trading systems such as Nyfix Millennium and ECNs like Island, which successfully trade exchange-traded funds (ETFs) away from the primary exchanges.

Competition is also coming from Nasdaq which operates The Nasdaq Intermarket-CAES (Computer Assisted Execution System) for NYSE- and Amex-listed stocks, where dealers post bids and offers. The Nasdaq Intermarket allows National Association of Securities Dealers (NASD)-member firms to direct orders in listed securities to market makers for near-immediate execution.

In addition, some institutions now prefer to trade Nasdaq stocks rather than NYSE-listed stocks, because the Nasdaq market is more democratic and transparent, sources contend.

"In the Nasdaq market, you've got the speed of execution, competition, anonymity and you've got much higher visibility of the prices," says Mizen. "When you bring up a screen with Cisco, you can see all the places Cisco trades, and all the prices displayed by ECNs. You don't get that same kind of feel in the listed market," she says.

With the frustration level so high, industry sources predict that buy-side institutions will take their business to ECNs, which they have already used on the over-the-counter (OTC) side.

Right now, 80 percent of the listed business is done on the floor of the listed-stock exchange, while 20 percent is done away. Of the 20 percent, Nasdaq dealers account for 11 percent of the listed volume, whereas ECNs account for about 9 percent.

"People have been calling for volume to come off the NYSE. The big difference now is that decimalization has raised the frustration for listed stocks (and) now the buy side - where the majority of volume comes from - they're basically saying, 'I don't want my order in the hands of someone who has a conflict of interest,'" says Wally Sullivan, chief executive officer of Pulse Trading, a Boston-based agency brokerage firm that specializes in using ECN on behalf of institutions.

ECNs claim their model removes such a conflict.

"Efficiency and consistency are right in our sweet spot," says Mike Cormack, president of Archipelago, which operates the Archipelago Exchange (ArcaEx). "Every time you send us an order, we're going to handle it exactly the same," he says.

But, when a buy-side trader is first in line at the NYSE and tries to execute a large order, they don't always get the trade done, contends Wheeler. "If I send an order down for 50,000 shares, (only) three or four people may want a piece of it," he says, so the trader may only get 10,000 shares executed.

Negative Obligation vs. Front-running

On April 17, the NYSE confirmed it was conducting an inquiry into whether or not several specialist firms had violated their "negative obligation" - the requirement that the specialist must "stand out of the way" when a natural match can occur between buyer and seller. The NYSE contended that its investigation was not focusing on "front-running."

Traders and analysts say the alleged impropriety relates to a practice known as penny jumping. Here's how it works: If a stock is bid at $20 and offered at $20.05, the allegation is that, "The specialist steps in and offers the seller 20.01 and then gives the buyer 20.04, and then the specialist makes three cents," says the head trader at a market-making firm, who declined to be named. The question is, "Should he just have let the buyer and seller do it at 20.02?" asks the trader.

"Penny jumping is similar to front-running," contends Damon Kovelsky, analyst with Financial Insights. "It's driving the buy side nuts. They're basically not getting market orders executed," he says.

Observers say allegations of penny jumping are serious because specialists are at the heart of the NYSE's floor-based market structure.

Specialists are, essentially, assigned-dealers who manage the auction market in specific stocks allocated to them. Because of industry consolidation, there are now only seven specialist firms responsible for matching buyers and sellers and maintaining a fair and orderly market in 3,364 NYSE-listed stocks.

Because of decimal pricing - where the minimum pricing increment is one cent - specialists are intervening in a higher percentage of trades than in the past.

According to the NYSE's Fact Book, specialists acted as either buyer or seller in 30.2 percent of the share volume traded in 2001.

American Century's Wheeler contends the figure is higher. "The specialists shouldn't be participating in 40 percent of the volume like they currently do," he says. "Their role should be to match buyer and seller, put them together and let them trade between themselves.

The practice has been going on for some time, but was exacerbated by decimalization, he contends.

"But what decimals did is lower the cost of entry from a sixteenth to just a penny," says Wheeler, making it more tempting for specialists to act as a counterparty.

"While you might not see it in the P&L of the specialists units, it is still a significant portion of what the specialist makes in profit by breaking up these trades and standing between them," Wheeler contends.

However, Richard Rosenblatt, president of Richard A. Rosenblatt & Co., an NYSE floor broker, says, "As business people, I would think they look forward to making money more than losing money. The question is, if they are making money, is it as a result of their performing normal duties as capital providers to the auction market, which they're required and expected to do, or is it a function of abuse of that position? Now, that is the question. I simply don't have that answer," says Rosenblatt.

As far as buy-side complaints about specialists, Rosenblatt contends that it is the same buy-side traders who have been complaining for the past decade. "They use the exchange's automated systems," he says. "A lot of their complaints seem to be based on (the fact) that the automated systems don't function as the execution process. They're not designed to," counters Rosenblatt. "(They're) designed to interact as a negotiated system."

Wheeler says that's the real issue at hand.

"That's kind of the root of the problem," claims Wheeler. "You have extremely efficient order delivery but extremely inefficient order execution," he says.

NYSE's Half Measures

In response to customer demands for automatic execution and competition from the ECNs, the NYSE introduced NYSE Direct+. "Direct+ is an auto-ex for small orders up to 1,099 shares, but (it executes) only every 30 seconds per user," explains Wheeler. Because institutions are having a hard time getting their executions done, they are spending time breaking up larger orders to put them through Direct+. "If you have a million-share buy ticket, you can get it done auto-ex if you break it into 1,000 share orders. I don't know how many 30-second segments there are in a trading day, but I don't think there's enough to fill a million share order," says Wheeler.

In recent years, the NYSE has responded to institutional calls for greater transparency by introducing products such as Open Book, which allows upstairs traders to view the top five best bids and offers on the specialist's limit-order book. But some industry participants say the information is useless since there is a 10-second delay.

"Open Book has been out for a while. It's a very defensive posture that they've always taken to try and keep the status quo. They delayed that Open Book data for 10 seconds. In the way the ECN world works (in sub-seconds), that's a lifetime," says Pulse Trading's Sullivan.

ECNs Breaking the Monopoly

As soon as the news broke that the NYSE was reviewing its specialists-trading practices for possible violations, the ECNs began taking steps to chip away at the NYSE's volume. On May 22, the Archipelago Exchange (ArcaEx) announced a record trading day in listed stocks of nearly 80 million shares. That is triple its normal volume of last year. Cormack says the momentum is building.

For years, institutions have been reluctant to move away from the NYSE's centralized auction market. Rule 390 - originally filed as Rule 394 with the Securities and Exchange Commission in 1957 - prohibited member firms from transacting a listed stock off an exchange, either as principal or agent. Though it was amended over the years, Rule 390 was not eliminated until 2001. "Because of their monopolistic position, you have to do business there, because most of the business is there," says the head trader, who declined to be named. But many buy-side firms are testing these alternative destinations for listed stocks before they send orders down to the floor.

Predicting that, "The buy sides of the Street are going to lead this ECN revolution," Sullivan says that ECNs will have the most success in trading listed stocks which are highly liquid. He suggests ECNs and buy-side traders will focus on the 28 stocks that make up the Dow Jones Industrial Average.

In what is likely no small coincidence, on May 1 Bloomberg launched a new Order Handling Facility (OHF) for trading U.S. listed stocks, starting with the 28 listed stocks in the Dow Jones Industrial's Index. Bloomberg's plan is to automatically integrate the NYSE with other fragmented pools of liquidity.

Pundits term this hybrid or blended trading, and they see this as the wave of the future.

In another competitive move, Instinet is releasing a tool that can send a slice of an order to the NYSE floor, while simultaneously representing the entire order upstairs in an anonymous way.

"We find, increasingly, that customers are willing to trade listed stocks on our system," says Instinet Chief Executive Officer Edward Nicoll. However, in order to increase the percentage of listed stocks it trades, Instinet would have to join the Intermarket Trading System (ITS).

Instinet - with 30 percent of Nasdaq volume and only four to five percent in NYSE-listed volume - is reluctant to join the ITS for fear it will slow down the ECN's electronic trading.

ITS Reform: Trade-Through Rule

If ECNs do 5 percent or more of their total transactions in listed stocks, they must join ITS - a communications network that links nine markets: NYSE, Amex, Boston, Chicago, Cincinnati, Pacific and Philadelphia stock exchanges; the Chicago Board Options Exchange and the Nasdaq.

One major obstacle to competing on a level playing field with the NYSE is the ITS trade-through rule. The ITS plan says that ITS participants shall avoid trading-through the national best bid and offer. So, if an ECN has a worse price than a participating exchange or market maker, it must ship the order to the exchange with the best price. The exchange has 30 seconds in which to send the order (called a commitment) to the specialist and await his response.

ECNs complain that the NYSE ignores the trade-through rule all the time.

The ITS trade-through rule "is somewhat of an obstacle right now," says Brian Hyndman, president of Brut ECN. "If the ECN or the (Nasdaq) Intermarket participant has a better price than on the New York, then they should execute away from the New York, and I don't believe that always happens," says Hyndman. Instead, they'll trade through, he says. They execute "with their own order flow out on the floor without trading with the other participants out on Nasdaq's Intermarket System," he adds. "That is a rather large obstacle for non-NYSE firms."

In September, the SEC instituted a "diminimus trade-through rule" with a three-cent exemption. ECNs are hoping that the SEC will make the pilot program permanent. "That allows the upstairs trader to trade up to a penny, two or three cents worse than the New York, in keeping with best execution. At the same time, (it) keeps that order out of the hands of the specialist, who has a conflict of interest," says Sullivan.

Cormack of Archipelago agrees with the goal. "Our view is that there should be a customer choice on the trade-through rule," he says. If there's a million shares of IBM offered at six cents on Island, and there's a million shares offered at five cents on IBM in New York, "I would imagine that every institution in the country would want to buy that million shares on Island at six cents first. It's very fast and you don't need to be exposed."

The SEC's nine-month pilot program expires in June.

Next Steps: No Status Quo

Pulse's Sullivan says three changes to existing practices are necessary to place the electronic-trading world on a level playing field with the NYSE floor. First, the NYSE needs to make Open Book real-time, Second, the NYSE needs to allow the integration of the its quote montage with the rest of the liquidity pools (ECNs and the Nasdaq Intermarket). Third, the SEC needs to roll out the three-cent trade-through rule for all listed securities, which Sullivan says will "be a catalyst for volume coming off the floor to all ECNs."

"The first two factors read like anti-trust 101," he says. "The fact that its (Open Book) is delayed at all is terrible because it puts the upstairs trader at a disadvantage." Furthermore, he says, upstairs traders need to see Open Book and the rest of the liquidity pools on the same montage and the NYSE is "not allowing that to happen."

Instinet's Nicoll says, "If we could have our quote displayed side by side with theirs (NYSE), and have people choose and not be required to send an order to New York and let people execute their orders here (on Instinet), then I believe we don't need any advantages. I think we'll be able to compete."

Though pundits do not expect the NYSE to go fully electronic, they do expect change.

TowerGroup's Mizen says, "The investigation is extremely serious, and it's unlikely that at the end of the investigation everything will go back to a status quo. I think you will see change either in the way that the ECNs interact with the exchanges, or in the tools that are available to satisfy some of the grumblings, whether it's really the cost or visibility or access or timing," she says. "But you will see change. I think seeing nothing is not an option."

Liquidity Quote: Is it Enough?

With complaints of penny-jumping from upstairs traders, the NYSE launched a pilot of Liquidity Quote - a real-time quote that shows the depth of market beyond the best bid or offer.

The NYSE Liquidity Quote is a compilation of orders on the limit-order book, the trading-crowd interest and the specialist as principal. The specialist adds up the cumulative volume of multiple orders at a single price point which becomes the Liquidity Quote. "So you have three facets of possible liquidity at a single price," explains John Wheeler, manager of equity trading at American Century.

For example, if the best bid is $15.15 and the best offer is $15.20 for 500 shares, Liquidity Quote may be $15.05 bid, $15.30 offered for 50,000 shares, says Samuel Lek, chief executive officer of Lek Securities.

According to Richard A. Rosenblatt, president of Richard A. Rosenblatt & Co., an NYSE floor broker, "You do not have to trade with the exposed bid or offer. You can go to Institutional Xpress (IX) to access the Liquidity Quote. In most cases, you can't do worse than that," he says.

To be "Xpressable," an order has to be good for 15,000 shares or more and available for at least 15 seconds.

"The problem is that Institutional Express has been barely used over the past year and a half, because it is rare that a (decimal) price can stay for 15 seconds," says Wheeler. The buy-side trader calls it a "thinly veiled attempt to appease the institutional community."

Lek calls this "an unnecessary complication to benefit the people who are physically present on the floor. You should be able to trade against that Liquidity Quote anytime, first come, first serve. You cannot. You can only trade against it electronically if it's been there for 15 seconds or more and becomes Xpressable," explains Lek.

The exchange is now talking about reducing the time frame to zero, says Rosenblatt.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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