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The membership of the Exchange may be classified by the functions performed." Some members are office partners of their firms and hold seats to entitle the firm to the commission-rate advantages of membership,15 while all others (aside from a small inactive group) are engaged in various activities on the Exchange floor itself. Floor members of the Exchange may be classified as follows: floor brokers (commission-house and "two-dollar" brokers), specialists, odd-lot dealers, and floor traders. Each of these functions is discussed below.

Until very recently the purchase of an Exchange seat generally entitled a person to the full privileges of exchange membership, with the exception that prospective specialists had to pass a test. Within the last few months, however, the two major New York exchanges have introduced an examination for prospective exchange members. A member who wishes to perform a particular function must take that part of the test covering the activity in which he proposes to engage. With the exception noted above, this is the first time in the history of major exchanges that simple membership will not carry with it the privilege of engaging in any exchange activity.48

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a. Floor brokers-commission-house and "two-dollar" brokers

Commission-house and "two-dollar" brokers are those Exchange members who actually execute orders on the floor of the Exchange as agents for others.

Commission-house brokers are members of member firms which receive and solicit orders from the public. Their function is to execute orders forwarded from their own firms or their correspondents. Their compensation depends upon their participation in the profits of their own firms, although the Exchange has a policy that a floor broker's participation must not be below a prescribed minimum.49

Two-dollar brokers are independent floor brokers not affiliated with a commission firm, although there are some firms composed of twodollar brokers. One of the main functions of these brokers and firms is to execute orders for commission houses having more business than their own floor brokers can handle. For this service the two-dollar broker receives "floor brokerage," which is a set minimum fee and is part of the total commission received from the investor.50 Unlike a specialist, who also holds and executes orders (usually limit orders, which cannot be executed immediately) for a commission-house broker, the two-dollar broker is available to execute orders at any post.51 Also, commission firms having no partners on the floor may enter into an arrangement with a two-dollar broker or a two-dollar brokerage firm to act as their agent to execute orders.

In recent years, certain two-dollar brokers have specialized in handling large orders which would normally occupy too much time

"See ch. I.B and tables I-3 and I-4 for a breakdown of membership as of Dec. 31, 1962. 45 For a discussion of commission rates, see pt. I of this chapter.

46 See ch. XII.

47 See ch. II.B.2.c.

See ch. II.B.2.d.

49 Rule 314 and supplementary material.

Do The term "two-dollar" broker derives from what at one time was the standard floor brokerage fee. Under present rules the average floor brokerage fee is about $3.50 per hundred shares. See pt. I of this chapter, containing a discussion of the commission

structure.

51 See sec. 2.b, below.

of the commission-house broker.52 Having achieved reputations for their ability in executing such orders quickly and without unduly affecting the market, these brokers come to know possible buyers or sellers of "blocks," and when they receive an order they may be able quickly to locate interest on the other side and arrange to match or "cross" the orders.53

b. Specialists

A specialist is an Exchange member who stays continuously at one post and participates in trading, as both broker and dealer, in the stocks in which he is registered with the Exchange as specialist. The continuous auction market and the division of the floor into posts creates two problems which have led to the development of the specialist system. First, brokers who have orders to execute at other posts may forward an order to the specialist, especially if the order is a limit order and the specified limit is remote from the current market price and therefore cannot be filled immediately. The specialist holds the order for execution when the market moves to the price specified in the order. Such an order may be transmitted to the specialist by floor broker or directly by the phone clerk through a tube system. CA second function derives from the fact that the continuous auction market is often too "thin" to insure that an order will meet its counterpart at a "fair" price. Where this is the case, it is the specialist's function to buy or sell for his own account at a fair price, to the extent necessary to maintain a "fair and orderly market." It is estimated that in about 60 percent of all transactions, the specialist in the stock will be on one side of a transaction or the other, either as a broker (when an order is forwarded to him by another broker) or as a principal. The specialist system, the various aspects of the broker and dealer functions and the mingling of the two functions are the subject of part D of this chapter.54

c. Floor traders

The floor trader, like the two-dollar broker, is a freelance member of the Exchange, but one who trades entirely for himself. Unlike the specialist, he has no responsibility in the execution of orders for the public or the maintenance of an orderly market. Some members are full-time floor traders, while others floor trade intermittently. These latter may often be floor members who trade for themselves when their other business is slack. Part F of this chapter discusses floor trading.

d. Odd-lot brokers and dealers

To avoid confusion in floor transactions, the major exchanges have long required that regular trading be done in standard quantities, termed round lots. On the New York Stock Exchange, the regular unit of trading in all except the most inactive stocks is 100 shares. All transactions in lots of fewer than 100 shares ("odd lots") are handled through odd-lot dealer firms. For example, if an investor desires to purchase 125 shares of a stock, 100 shares will be purchased as

52 See ch. VIII.C: occasionally these brokers may be contacted and given orders directly by institutional investors rather than through a commission firm. In such cases the member must charge the nonmember the full prescribed nonmember commission and not just floor brokerage, even though only a floor brokerage was performed. See pt. I of this chapter.

5 See ch. VIII.C.

54 See also ch. VIII.E., dealing with regional stock exchange specialists.

a round lot and the balance as an odd lot. The function of the odd-lot dealer, therefore, is to purchase or sell as principal to meet all odd-lot orders presented by Exchange members. On the NYSE, the odd-lot dealers retain the exclusive services of a large number of associate brokers who execute odd-lot orders and also trade round lots in order to offset the long or short positions acquired in odd-lot trading for the dealer firms. A discussion of the odd-lot dealers, the associate brokers, and the mechanics of their operation appears in part E of this chapter. C. MEMBERS' TRANSACTIONS

1. INTRODUCTION

In the year 1961, member purchases and sales as principals in the round-lot market of the New York Stock Exchange totaled 524,527,000 shares, or 24.6 percent of all purchases and sales in the round-lot market. This significant member participation in trading on the Exchange is accounted for by various types of members, each of which tends to display distinct trading patterns and motivations. Floor traders, for instance, buy and sell for their personal accounts on the floor of the Exchange, primarily seeking quick profits on "in-and-out” transactions. Other members on the floor trade not for personal investment or speculation, but rather to facilitate the purchase and sale of stocks by others. Odd-lot dealers station their associate brokers on the floor to buy and sell odd lots (not included in the share total), and to offset their positions acquired in odd-lot trading in the round-lot market. Specialists are registered in stocks which they are expected to buy or sell, under certain conditions, in order to provide orderly roundlot markets. Those members who trade from off the floor, which includes virtually the entire Exchange membership, are the least homogeneous grouping of members in terms of trading patterns and motivations, for their trading represents a broader mixture of personal investment or speculation, arbitrage transactions, dispositions of personally held allotments of new offerings, and other operations.

In a great many instances this member participation in the market, especially by specialists and odd-lot dealers, improves the quality and usefulness of the exchange markets. On the other hand, permitting members to trade in securities as principals raises two fundamental problems, both of which were spotlighted by the congressional hearings which produced the Securities Exchange Act of 1934.

The first is a conflict-of-interest problem which assumes many forms in the securities business. Most members of the public deal with exchange members as brokers; that is, as agents or fiduciaries. If the member trades as principal--as an underwriter, as a specialist with his own capital at risk in his assigned stocks, as an owner of stock in any way-his investment advice or his handling of public orders may be subject to bias by virtue of his own interest. The second problem raised by members' trading as principals is that their trading may be such as to unduly influence price movements or excite excessive speculation.

With a view to preventing the type of price manipulations and conflicts of interest uncovered by the congressional hearings, the

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See Senate Committee on Banking and Currency, "Stock Exchange Practices," S. Rept. 1455. 73d Cong., 2d sess. (1934). See also Hearings on Stock Exchange Regulation Before the House Committee on Interstate and Foreign Commerce, 73d Cong., 2d sess. (1934) (hereinafter cited as "House Hearings").

originally introduced version of the Securities Exchange Act prohibited virtually all principal transactions by members of exchanges, possibly even including transactions for personal investment.56 The bill provided, in short, for the "segregation" of broker and dealer functions, and contemplated "pure" exchange markets made up exclusively of brokers.

In the hearings which followed the introduction of this bill, the exchanges argued that elimination of the dealer activities of various members would severely disrupt or destroy the exchange markets. Faced with the complexities of exchange legislation for the first time, Congress responded by deleting in progressive steps the segregation provisions of the original bill. Thus, the first amended version of the bill 57 prescribed that "Membership of a national securities exchange shall be limited to brokers ***," but provided several fundamental exceptions to this limitation. If not in contravention of rules of the Commission, members could register as combined broker-dealers, but under no conditions could these functions be combined by members "while on the trading premises" of an exchange, nor could a broker effect any transaction for his own account while on exchange premises. Members could register as odd-lot dealers or specialists, but each specialist could act only as a dealer or a broker, not both. In this and all subsequent versions of the bill, and in the act as passed, Congress made clear the fact that its treatment of the segregation problems was not to be considered a final solution by directing the Commission "*** to make a study of the feasibility and desirability of the complete divorcement of the functions of dealer and broker * * *” and to report, with recommendations, the results to Congress by January 1, 1936.

The amended segregation proposal was deemed to be unnecessarily harsh by the president of the NYSE, who testified:

I cannot believe it is wise to make such a revolutionary change in the accustomed method of doing business until it is shown that any possible abuses cannot be eliminated in some less drastic manner. I suggest, therefore, that this section be amended so as to allow the Commission to adopt such rules and regulations as it may deem necessary in regard to members of an exchange combining the function of dealer and broker when actually engaged in business on the floor of the exchange. This suggestion will give the Commission full power to change and correct its rules as conditions may require. Such a power is essential to experimental regulation in so technical a field and is not possible under fixed rules of law.58

This approach was, for the most part, adopted in a subsequent committee print of H.R. 8720, which directed the Commission to

prescribe rules and regulations (1) to prevent floor trading by members of national securities exchanges, directly or indirectly, for their own account or for discretionary accounts, and (2) to prevent such excessive trading on the exchange, but off the floor by members, directly or indirectly, for their own account, as the Commission may deem detrimental to the maintenance of a fair and orderly market.

H.R. 7852, introduced by Congressman Rayburn on Feb. 10, 1934, 78th Congressional Record 2378 (1934). Sec. 10 provided that: "It shall be unlawful for any member of a national securities exchange to act as a dealer in or underwriter of securities..."

A limited exception provided that specialists could act as dealers, but only to the extent of effecting transactions on "fixed price orders." Although not incorporated in the bill, the House Committee on Interstate and Foreign Commerce felt an exception for odd-lot dealers was appropriate. House Hearings at p. 123.

H.R. 8720, introduced by Congressman Rayburn on Mar. 19, 1934. 78th Congressional Record 4876 (1934).

House Hearings at p. 725.

"See sec. 10 of the House or Senate committee print dated Apr. 4, 1984.

The prohibition against floor trading was qualified by a subsection that permitted members-if the Commission concurred-to combine broker and dealer functions as specialists, and to register as odd-lot dealers. Finally, in a subsequent amendment of the bill, the directive to "prevent" floor trading was modified, giving the Commission authority to "regulate, limit, or prevent" such trading.

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As passed, therefore, the 1934 act did not establish the segregation of broker and dealer functions, nor did it eliminate any type of member or member function. Instead, the act relied on certain prohibitions against the manipulation of security prices and the use of manipulative and deceptive devices, and conferred on the Commission broad powers to regulate members' trading in section 11.61

The Commission's "Report on the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker," completed in 1936, concluded that "*** it is not advisable for the Congress at this time to enact legislation requiring the complete segregation of the functions of dealer and broker." 62 At no time has the Commission found it necessary to prescribe any rule under the powers granted it by section 11 of the act. It has, however, encouraged the exchanges to adopt rules to prevent excessive trading by members and to meet other problems arising out of such trading. Later parts of this chapter-dealing with specialists, odd-lot dealers, floor traders, and off-floor traders-treat these problems and the rules designed to meet them in detail. This part is restricted to a general description of member trading, including the volume of such trading, its relationship to price movements, and the extent of its concentration in stocks by price, price range, and activity.

2. METHOD OF STUDY

Three 1-week periods ended January 27, March 24, and June 16, 1961, were selected for study. During these weeks the Standard & Poor's "500" Stock Composite Index changed +1,28, -0.18 and -1,48 respectively. Data covering member trading in each stock each day over these periods were obtained from reports of trading activity filed by members with the NYSE, questionnaires, and other sources. These sources are further described in appendix A, and in each of the following parts of this chapter that deal with member trading activities.

3. VOLUME OF MEMBERS' TRANSACTIONS

Between 1937 and 1942 total round-lot purchases and sales on the NYSE declined from 897 million shares to 267 million shares per year, and over this same period member participation dropped from 23.9 percent of total round-lot purchases and sales to 18.4 percent (table VI-1). The year 1943, however, marked the beginning of a long-term increase in both total Exchange volume and member participation rates. In each of the years 1958 through 1961, round-lot purchases and

60 House subcommittee print, Apr. 18, 1934. A subsequent draft of the bill H.R. 9323 struck the word "limit"; there was no further change in this phrasing. See sec. 6 of pt. F, below. 61 Sec. 10 of the bill became sec. 11 of the act.

62 SEC, "Report on the Feasibility and Adyisability of the Complete Segregation of the Functions of Dealer and Broker" at p. 109 (1936) (hereinafter cited as "Segregation Report").

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