A. It certainly helps the seller. Anything that creates activity in a stock, rather than false activity, is good for the market. The larger the marketplace the better to have it all in one place.

Q. Isn't it the stock like

*

[an inactive stock] that needs a better market? A. Well, they [floor traders] have to make money or they wouldn't be in business. There is no sense tying your money up in [the stock]. It might go down. There might be a seller there, and it might take you a week to get out. Q. Isn't a stock like Ampex [in which floor traders were active] generally a liquid stock, without the floor traders?

A. It could be, but he makes it more liquid.

Q. Do you think that is a stronger consideration than balance a buyer of the stock in a period of a rising market?

whether he is on

A. Well, then the seller is ahead. The more volume you have in any stock, the more liquidity in any stock and the more chance the public can do whatever it wants to do.

Another prominent specialist testified that floor traders "*** add greatly to the liquidity of the market." He noted, however, that floor traders were most active in Litton Industries, his most active stock, but that he could recall no floor trading in the last few years in Best & Co., a very inactive stock. He explained the absence of floor trading in Best & Co. as follows:

There is very little opportunity for it because the transactions are so sparse that it would be almost-well, it seems impossible for a trader to stand around and wait for 100 shares of Best that might happen to be there.

That floor trading tends to abate or disappear under stress conditions was affirmed by the specialist in International Business Machines Corp. who testified as follows with respect to that stock during the May 28 market break.

Q. Did you have bids in substantial quantities within 20, 30, 40, or 50 points of the market?

A. There was no substantial bid anywhere, and in a case like this you couldn't get help from people. Nobody wanted to buy anything.

Q. The floor traders were not too interested?

A. They weren't interested at all. They had seen the light."

462

There is, then, general agreement that floor traders contribute to the liquidity of the market. It is clear, however, that the liquidity they provide is in most cases marginal, for they tend to enter the market only when other investors have already provided activity, a fact that poses the interesting question, "Who is providing liquidity for whom?"

It is indeed probable that on occasion the liquidity added to the marketplace by floor traders constitutes a positive disservice to the public by creating a misleading impression of a given stock's actual liquidity. Thus investors who purchase a stock with a view to liquidity may find in stress situations that the floor traders, who are under no obligation to maintain fair and orderly markets, have abandoned the stock, and its liquidity has been impaired when it is most needed. b. Market continuity

Another defense of floor trading that is often raised is that floor trading improves the continuity of the market, or provides a "closer"

462 Floor traders had a net sale balance in International Business Machines Corp. of 1,600 shares on May 28.

market. That is, the presence of floor traders is said to increase the probability that transactions in a given stock will be effected at or very close to the price of preceding transactions in the stock. Thus, if a stock is quoted 50 to 1/2 following a transaction at 504 in a relatively stable market, a floor trader may narrow the quotation by offering stock at less than 5011⁄2 or bidding more than 50. This narrowing of the spread will ordinarily result in a transaction closer to the last sale than if the market remained 50 to 12.

This defense of floor trading, however, is subject to the same qualifications that deprive the liquidity defense of much of its weight. Since floor traders concentrate their activities in the active stocks, their contribution to continuity is limited for the most part to securities which suffer least from lack of continuity.463 Moreover, the continuity supplied by floor traders is attributable to trading that generally tends to accentuate price movements and thereby impair price stability.

In fact, this tendency to accentuate price movements may manifest itself in a manner that has a directly negative effect on price continuity. As has been noted, floor traders tend to avoid stable markets, preferring to trade in "stocks that are active and that have had a break or rally." Here floor traders are more apt to add to the imbalance of buyers and sellers than to bring them into balance, thus accentuating the price movement. If, for instance, a stock is quoted 50 to 1/2 following a transaction at 50 in a rising market, floor traders may intensify the competitive biding so as to drive the price up to 504 or higher, thus impairing both price stability and continuity.**

Moreover, as the exchange has often publicly explained, it is primarily the specialist's obligation, and not the floor trader's, to maintain price continuity. This is as it should be, for the specialist is expected to provide such continuity in good times and bad, whereas the floor trader, who has no responsibilities whatever, may simply withdraw from or indeed aggravate-stress situations to the detriment of other investors.

c. Market stability

Despite the consistent findings that floor traders as a group tend to trade with price trends, or in a destabilizing fashion, the Exchange has maintained that floor traders exert a stabilizing influence on the market. This argument usually takes one or more of three forms: (1) floor traders stabilize declining markets when they cover short sales, (2) in many cases floor traders trade against the trend in the market as a whole or in individual stocks, as measured by net purchase or sale balances, and (3) as measured by "tick" tests, a majority of floor trader transactions are against the trend.

The argument that purchases to cover short sales tend to stabilize declining markets overlooks the fact that such purchases are only a portion of total purchases, and are fully accounted for in net balance studies, which show that in declining markets floor traders generally tend to sell more than they buy.465 The second point-that floor

463 See pt. D.5, above.

464 The relative number of times floor traders impair rather than improve price continuity has not been studied, due to the fact that it is impossible to reconstruct the market situations in which floor traders participated in the auction. No record is kept, for instance, of bids and offers made at particular times at the post, and it is therefore virtually impossible to ascertain whether a floor trader's presence affected the auction proceeding and resultant price of a transaction.

40 Short selling is treated in pt. H, below.

trader net balances are in many cases against the trend-is certainly true, but likewise does not undermine the finding that on the whole floor traders trade with price trends, and more often than not exert a destabilizing influence on the market.

Brief treatment of the use of tick tests for floor traders is appropriate at this point. From time to time the Exchange has brought to the Commission's attention instances where floor trading appeared to have a stabilizing influence on the market or on a given stock, but only once has the Exchange submitted a report designed to rebut Commission findings that floor trading has an overall destabilizing influence on price movements. This report the Cole, Hoisington, or Exchange Report-challenged the Commission's statistical methods, reinterpreted certain of the Commission's statistics, and presented certain examples of floor trading activity that appeared to stabilize the market. With respect to net balances studies the Exchange Report argued that floor trader net balances over weeks or months have little bearing on the effect floor traders have on price trends, in that such balances "*** are very small in relation to the total volume of floor trading activity, and are insignificant in relation to the total volume of trading on the Exchange." With respect to daily floor trader net balances, the Exchange Report noted that aggregate floor trader balances during a 17-day period in September 1937 previously studied by the Exchange showed trading with the trend on a daily basis on 10 of the 17 days, or 59 percent of the time. The report went on to say, however, that stabilization should be measured by a transactionto-transaction, or tick, system rather than by net balance studies. That is, all purchases on minus ticks and all sales on plus ticks should be considered "stabilizing," or against the "trend" indicated by the direction of the price change from one transaction to the next.

To this end, Cole, Hoisington studied floor trading in five selected stocks over the 17-day period by 15 floor traders who had "short sales of as much as 2,000 shares in any one or more of the five stocks" over the 17 days.

This study produced the following results:

The Exchange Report therefore concluded that these figures indicated a "*** preponderance of directly stabilizing transactions over directly nonstabilizing transactions." Of the 217,900 shares traded on zero-plus or zero-minus ticks, or "neither with nor against," the report found that "116,600 or 53.5 percent may be considered as having an indirect stabilizing effect." There is in these data, however, a strong built-in bias. Prior to the period covered by this study a Commission rule, which is still in effect, had been adopted which prohibited short sales on minus ticks. Selecting members with substantial short sales as the basis for the study, therefore, insured inclusion in the data of a large number of transactions that could not, a priori, fall into the "destabilizing" or "with price change" category.

In contrast, a study covering the weeks ended January 27 and June 16, 1961,166 indicates that even as measured by the tick system, floor trading tends to be destabilizing in nature (table VI-72). On all 6 days on which the price index increased a greater percentage of floor trader purchases were destabilizing than stabilizing, and on 3 of the 4 days of price decline a greater percentage of their sales were destabilizing than stabilizing. Combined purchases and sales were less than 50 percent stabilizing on 6 of the 10 days. 467

Of even greater significance are the theoretical shortcomings of this tick approach, treated in detail in the part on specialists, above. Briefly stated, the major fault of this approach is that it equates a "price change" with a "price trend." As a result of this semantic adjustment the term "trend" is given a meaning different than that given it in general usage, and floor traders may be heavy sellers in declining markets or heavy buyers in rising markets and yet be described under the tick test as stabilizing influences, simply by purchasing on the minus ticks appearing from time to time in a rising stock or by selling on the plus ticks occurring in a declining stock. 468 For example, a stock may open at 20 and rise to 24 by the close, never trading below 20, on, say, 200 round lots traded on zero-plus ticks, 150 round lots on zero-minus ticks, 90 round lots on plus ticks, and 60 round lots on minus ticks, for a total day's trading of 500 round lots or 50,000 shares. According to the Exchange's tick test, if floor traders purchased 100 shares on each minus tick and sold no shares whatever during the day, their trading would be deemed to be 100 percent directly stabilizing, despite the fact that they were heavy purchasers of a stock experiencing a sharp price rise. For these reasons it is clear that net balance studies should provide the basic measure of the stabilizing or destabilizing nature of floor trading, and these studies consistently show that floor trading accentuates price

movements.

On occasion the Exchange has argued that even if floor traders did accentuate price movements, this would not necessarily be undesirable. Thus it was stated in the Exchange Report:

Nowhere in the Trading and Exchange Division's report is attention directed toward the interests of the public seller. Even if the floor trader did customarily stimulate public buying interest, and did bring about unwarranted price advances, this should at least mean that some public sellers had been able to dispose of their stock either sooner, or at better prices, than would otherwise have been possible. [Emphasis added.]

This argument adds nothing to the defense of floor trading, because it goes too far. It is desirable to have, in any auction market, sufficient buyers and sellers to maintain a liquid and continuous market. It is also desirable to have public buying and selling supplemented, to the extent necessary to provide liquidity and continuity, by that of a

466 Of the three 1-week periods studied, the week of greatest market rise (ended Jan. 27) and the week of greatest market decline (ended June 16) were selected for tick analysis. 407 See testimony of E. H. Stern in subsec. 3.b (2), above. Also, compare the vastly higher stabilization rates of specialists in pt. D, above.

488 It should be noted that in addition to ticks created by trading in which the specialist does not intervene as principal (a form of trading that best reflects the "mood" of investors), many ticks are created by the specialist trading on his spread-a form of movement that does not reflect the public's evaluation of price (or trend) so much as a time lapse between "matchable" investor buy and sell orders.

409 In an analysis of actual price trends over the course of a day it was found that in most cases there were a large number of ticks against the trend. See pt. D.6.e(2).

specialist, who functions as a matter of obligation and under specific regulation. It seems sophistic to go beyond this, however, and argue that any purchases in a rising market-even in a market whose pace may have been accentuated by transactions of that purchaser-make a positive contribution by giving sellers the opportunity to sell at higher prices.470 The argument that sellers benefit from rising markets (or that buyers benefit from declining markets) could be made as to many types of transactions now prohibited as deleterious: permitting such transactions might enable someone on the other side to buy or sell at a better price than he would otherwise obtain. If floor trading is destabilizing or otherwise deleterious, this kind of benefit to specific members of the public who may sell at higher prices or buy at lower prices is no more pertinent than it would be as a justification of pools or manipulations. The point is even broader: Whenever a market lacks continuity or stability for any reason, whenever a transaction is effected in error, or whenever a broker obtains less than an optimum. result for his customer-in short, whenever the mechanisms of the market fail to operate at their normal best-a buyer or seller on the other side may benefit; yet this incidental benefit obviously is not considered by the Exchange as a reason for tolerating anything less than the best possible market mechanisms and standards.

5. FLOOR TRADERS AS QUASI-SPECIALISTS

There is a unique species of floor trading that does not seem to fit, in some respects, in the traditional patterns of accentuating price movements, following rather than providing activity or liquidity, and retreating from or accentuating rather than countering stress situations. This trading is concentrated in a few floor traders who voluntarily act from time to time in a quasi-specialist manner by taking or supplying large blocks of stock. In some cases one or another of these floor traders, who must be sufficiently capitalized to take or supply large blocks, will be approached by a floor broker with a sizable buy or sell order. The reasons for seeking out a floor trader in such situations were outlined in the testimony of an independent floor broker who handles large orders for several member firms. He noted that this practice was a secondary procedure rather than a regular procedure, which he turns to "*** if I can't work it out otherwise." The prime factor in determining whether the order can be worked out otherwise is the willingness of the specialist in the stock to make a sizable bid.

A. * You are very much aware of the fact that the large [specialist] firms, the ones I have mentioned, are large, are the ones that have good financial situations and they can handle it.

A lot of the other specialists obviously haven't, aren't in the same position financially and they can't handle it. They make a regular market as they are supposed to; they make good ones, but when it comes to size, financially they are not able to.

470 Indeed this argument is inconsistent with and-if valid-would require the elimination of specialist market functions. In performing his function the specialist will often deprive a willing seller or buyer of a "bargain" transaction. Appropriately, the Exchange does not consider this a valid reason to prohibit specialist participation in the market. The Exchange, in short, considers a continuous market far more desirable than one that provides opportunities to individual buyers or sellers to snap up bargain transactions. See pt. D, above.