orderly market. The fact that the tick test showed 100-percent stabilization was not discussed-probably because its inadequacy as a measurement of stabilization is apparent in this case.

No one would suggest that the specialist had a duty, or that it would have been proper for him, to "peg" the price by buying all the offered stock at the opening price. On the other hand, it will be recalled that the Exchange has pointed to the specialist system as necessary to prevent unreasonable and excessive fluctuations which inter alia destroy the value of securities as collateral.279 The technical price continuity provided by the specialist in this stock did not meet this criterion.

Had the specialist even doubled the size of his bids from 100 to 200 shares the decline would probably have been substantially less than it was: The specialist, by giving reasonable size (under the circumstances) to his bid or offer at a particular level, adds depth as well as continuity to the market. Although the effect here would have been to reduce the price movement of the stock, this would not have been the purpose of the specialist's transactions. The purpose would have been to give the stock adequate volume at each price level. Markets without depth detract from the worth of quotations and previous sales as indications of value. This does not mean that stocks selling at high prices should only move in the smallest fractions permitted; it does mean that in addition to reasonable price continuity the specialist should provide reasonable depth.

In fact, in specific cases the Exchange has occasionally criticized specialists for failure to give markets depth.280 Yet none of the routine tests are used in such a way as to isolate this factor. Although the complex factors involved cannot be reduced to a mechanical formula, if the tests focused on the extent to which specialist trading prevented prices from reaching new levels, in light of the quantity and the purchase or sale predominance of public activity, there could be a clearer indication of specialist performance. The Exchange's present measurements focus only on price continuity and on the specialist's participation without attempting to combine the two, so that no judgment can be made as to whether a market is satisfactory as a result of the specialist's trading activities or whether such activities are "reasonably necessary." In effect, the Exchange may be measuring the public market. And as was pointed out above, the best way that specialist performance can be measured significantly is by the specialist's trading pattern in, and impact upon, a specific stock on a specific day.

There is no doubt that by providing depth in both good markets and bad, the specialist is more likely to accumulate an inventory and thus increase his risk. However, the business of the specialist is not an unrewarding one. A responsibility to provide continuity with depth is the reasonable concomitant to the many privileges specialists enjoy. In positioning himself for anticipated price movements the specialist may trade to accumulate inventory, which would increase his dealer profits beyond the "jobber's turn" if his market judgment is correct.281

279 See sec. 6.a, above.

280 It is puzzling that this concept only appears by implication in the Columbus & Southern file.

281 It may be noted again that the specialist, with his exclusive knowledge with respect to his stocks, is in a better position to make an informed judgment than anyone else. As one specialist testified:

"I sensed a general rise in the market, as you do. You can tell after you have been there 40 years. Why you can tell whether the market is going up or down."

One specialist testified that, as a result of his judgment of market conditions, he tries to adjust his inventory:

A. * * If the market is going up, you try to be on the long side. If the market is going down you try to be on the short side.

Q. This from the standpoint of whether [specialists] are going to be able to make money in their dealer transactions?

A. This is right.

Both the accumulation and liquidation of inventories in anticipation of price movements permit the specialist to trade with the trend.282 Thus, in a rising market the specialist may occasionally tend to purchase moderately on balance-and is permitted by the Saperstein Interpretation to do so-in anticipation of being a seller as the price continues to increase. Conversely, anticipating a decrease in price, the specialist may tend to become a seller on balance and take a short position in anticipation of being a purchaser during the decline. In either case, at the completion of the process, the specialist is in a position to act in some degree as a stabilizing force; at this point a degree of depth in his market may logically and fairly be expected.

The connection between specialists' positioning themselves and adding depth to the market is not a new one. In his 1941 book, Vernon stated that the possibility existed:

that in crucial periods the specialist foresakes *** trading "with the trend" and offers much needed support, or otherwise acts to stem a sharp unwarranted rise or decline in stock prices. Perhaps such exceptional behavior, if it exist[s], would be of sufficient weight to offset *** [a] tendency to exaggerate stock price movements."

283

It must also be remembered that the specialist is not purely dependent upon his trading acumen for his income. Not only does the book serve on occasion as an outlet for excessive inventory, but the brokerage function serves as a relatively riskless source of income.284 Although the arguments against the separation of the brokerage and dealer functions have been stated in various ways, the common theme has been that the functions are interdependent-an interdependence that reenforces the view that the specialist as a market maker has a responsibility to provide markets with reasonable depth. If the conflict of interest between the two functions is to be tolerated the duty to the customer must include the obligation to maintain markets which are fair and reasonable: This is the only basis on which an agent who intimately affects the market in which his principal deals can and should be permitted to occupy a position technically adverse to his principal. Since access to the floor confers substantial trading advantages, even without the special knowledge available to the specialist, the privileges enjoyed by the specialist are compatible with the

282 See sec. 6.b, above, where the specialist purchased all of the offered stock in American Natural Gas, contributing to an immediate increase in price; see also the cases cited there where the Exchange seems to have evolved a rule of thumb limiting such transactions to 50 percent of the offered stock so as to ameliorate the effect of such transactions.

The one-third of the stocks in the study (discussed in sec. 6.e(3), above), which had balances with the trend as well as a high number of destabilizing transactions, may represent extreme manifestations of these practices.

283 Vernon, "Regulation of Stock Exchange Members," pp. 93-94.

284 At the time of the Segregation Study it was argued that the brokerage function entailed enormous contingent liabilities. As a practical matter the only possible liability is "missing the market," and many specialists testified that this very rarely happened to them because of their central location in the marketplace. The only specialist who testified that he missed markets with some frequency stated that this happened because he often attempted to better a cusomer's limit and in doing so, would miss the market if his judgment erred.

statutory scheme only if his duties to the public investor are not terminable at will but continue reasonably through good markets and bad, through profitable and unprofitable periods. In finding the balance between profit and responsibility, the regulatory processes must evolve a more sophisticated approach to the examination of specialist trading, its market effects, and the profitability of the business.

h. Specialists and block transactions

The role of institutional investors on the New York Stock Exchange has increased substantially over the last 10 to 15 years.285 The needs of these investors are sometimes different from those of the smaller investors because institutional transactions are more likely to involve a large number of shares. Blocks of shares are often too large to be readily and promptly absorbed or supplied through the routine procedures of the auction market, but not necessarily so large as to require the use of any special distribution or acquisition plan.286 The specialist, stationed in the center of the auction market, has an important role in the handling of blocks both as broker and as dealer.

There are substantial differences among specialists as to their dealer activities with respect to block transactions. Differences in capital ability and willingness to assume risks are reflected by the fact that some specialists will frequently make bids for 10,000 shares, whereas other specialists will limit their purchases to 5,000 or 6,000 shares and will not normally buy more. One specialist felt that his function is not to buy blocks but to stay in a liquid position in order to provide market continuity. Specialists who have achieved a reputation for dealing in blocks may be contacted directly by, and trade directly with, investors who desire to deal in large blocks. 287 Other specialists, as a matter of philosophy, refuse to deal directly with such investors and insist that all orders go through the office of a regular commission firm. The differences of ability and willingness of specialists to deal in blocks has been noticed by institutional investors, one of which stated in answer to questionnaire IN-4 that the over-the-counter market in listed securities 288 was used when the Exchange market was "thin or unorderly *** in a particular stock." Another stated that over-the-counter dealers often had NYSE-listed securities available "at lower net prices and in greater volume." A third responded as follows:

* The greatest single problem for an institution, in my opinion, is the thinnest of the market for most stocks and the enclosed forms indicate the tremendous amount of paperwork and expense involved in acquiring a block of stock on the stock exchange where we must buy a few hundred shares at a time. In an effort to avoid this we often trade blocks over-the-counter.

Finally, one institutional investor wrote:

From time to time we have felt that some of the specialists on the New York Stock Exchange were not active enough in their assigned stocks. We wonder if

285 For a discussion of institutional participation and block transactions, see ch. VIII.C. Over 60 percent of the specialists noted in questionnaire EX-1 that over the last 5 years the number of blocks has increased.

286 These special plans are discussed in chapters IV.D and VIII.C.

Of course, the number of shares constituting a "block" varies for different stocks, different specialists, and the state of the market; e.g., for some stocks 1,000 will be considered a large block while for others 5,000 or 10,000 will not be thought too large to handle ordinarily.

287 One former chairman stated that he deliberately seeks to be known as a specialist who deals in blocks because this "brings us business."

288 See pt. D of ch. VIII for a discussion of this market.

the standards, which have been established by the board of governors of the stock exchange for judging whether or not a specialist is adequately fulfilling his responsibilities are sufficient.

Two experienced specialists testified that the basic problem in connection with blocks is to get the specialist to make a bid at no more than a reasonable discount from the last sale. Underlying this is the fact that a specialist purchasing a block faces the same economic problem as that present in dealing in an inactive stock, i.e., it may be some time before sufficient matching counter orders arrive, and until that time the specialist is left with an inventory at the risk of the market and with his capital tied up.

Aside from willingness to deal, the capital ability of a specialist is of obvious importance. The best capitalized specialists are known for their ability to make substantial bids. The three units with the largest aggregate long and short position at June 16, 1961, had 27.0 percent of all specialist positions. These units represented 31.8 percent of total specialist capital used in carrying positions (during 1960), and had capital per assigned common stock ranging from $130,000 to $550, 000. In contrast, the average capital per common stock for all units. was $60,000.

Thinly capitalized specialists who want to bid for a block but are close to the 25 percent maintenance requirement must get permission from their clearing agent to go below this level. One clearing agent testified:

Occasionally a specialist will be asked to make a bid on a block of stock in which he is registered as a specialist. He knows if he does it is going to bring him below the 25 percent. He might come by and say to me, "Is it all right if I bid for [a] block of stock and if I buy it will bring me below the 25 percent." I will figure up what money is and the answer is generally "Yes." Because he is not an investor, he is going to peddle it.

In 1953 an Exchange-appointed committee studying "Broadening the Auction Market on the New York Stock Exchange" recommended an increase in specialists' capital requirements. However, no action was taken then, and when the matter was studied 2 years later the proposal was not repeated; this latter study is discussed below.

Various techniques involving the participation of specialists have evolved for the handling of blocks. Specialists may purchase the block as principal, either within the market or off-board under the provisions of rule 107 (a), permitting purchases of blocks by specialists off the Exchange.289 The block is often purchased at a discount from the last sale. The discount serves as a limited hedge against market drift and is functionally similar to a wide spread in inactive stocks.290 The amount of the discount will depend in part on the activity of the stock and the inventory position of the specialist. A realistic discount from the seller's viewpoint may not adequately protect the specialist from market risks. Confirmation of this is found in the experience of specialists, one of whom testified that where the book was thin a moderate discount was not sufficient since "*** I kind of felt I would have a poor opportunity of disposing of my stock in the open market."

280 There is a parallel sale rule, rule 107(b).

200 There is a countervailing factor not present in inactive stocks. When the ticker tape reflects the cleanup of a block, a flurry of buying activity is often stimulated, at which time the specialist supplies stock to the market and thereby liquidates his block and keeps the market orderly.

An examination was made of specialists' activities in purchasing blocks within the Exchange market and under rule 107(a). All specialist purchases within the market of 2,000 shares and over, during the 3-week study, were analyzed to determine the size of blocks that specialists were willing to buy, the discount at which they purchased, and the prices at which the specialist liquidated the block. Of the 1,128 transactions of 2,000 shares or over that appeared on the ticker tape, specialists were the purchasers in 277 instances, or 24.6 percent of these transactions.291 More than 40 percent of the blocks that specialists bought were over 3,000 shares, 16 percent were over 5,000 shares, and 4 percent (12 blocks) involved 10,000 shares or more (tables VI-40 to 42).

The study indicated that specialists purchased 135 blocks within the market at no change from the previous sale, 44 at a discount of %, 31 at 14, and 36 at prices above the previous sale.292 The differences between the price and the previous sale price could not be determined in 14 cases.

A weighted average price of successive long sales by the specialists up to the amount of the block purchase was calculated in 139 of the block situations. The following is a distribution of the profit per share among the 139:

TABLE VI-j.—Distribution of profit per share of specialists' purchases of 2,000 shares and over

This indicates that when specialists purchased blocks they usually did so without disturbance to the market and in most cases without an unreasonable profit in the liquidation of the block.

Under rule 107 (a), the specialist is permitted to buy a block offboard at a discount, with nothing appearing on the tape. He may make such a purchase with the approval of a floor governor, if in the judgment of the governor "the regular market on the floor of the Exchange cannot, within a reasonable time and at a reasonable price or prices, absorb or supply the particular block of stock, and that the purchase or sale will aid the specialist in maintaining a fair and orderly market." 293 The specialist need not fill the bids on his book between the current bid on the floor and the price at which he bought. For example, if the last sale price was at 30 and the specialist held bids on his book at that price and at prices down through 29, and he bought the block at 28%, he would not have to fill the orders of these

customers.

201 The information for this study was obtained from two different sources. The number of specialist purchases came from reports that specialists filed with questionnaire EX-1; the number of blocks printed on the ticker tape came from the Fitch Sheets. No attempt

was made to match specialist purchases with transactions appearing in the Fitch Sheets. 292 This study cannot be deemed to be conclusive since a few transactions preceding the purchase may have represented smaller portions of the block being executed at declining prices.

203 NYSE Guide, par. No. 2107.10.