influence on the stock days in which they traded. Data for the 3 weeks studied produced just such a pattern (app. VI-A, chart 4 and table 4).70 Aggregate member trading for the period studied, therefore, exerted a rather clear stabilizing effect on stock day price

movements.

On most of the stock days in which members traded over the 3 weeks, however, their net balances were small. Member purchases exactly equaled member sales in 8.8 percent of all stock days in which any member participated. Odd-lot dealers posted zero balances in 5.4 percent of the stock days in which they participated, while floor traders posted zero balances in 11.9 percent of their stock days. Specialists and members off floor had zero balances in 9.4 and 7.6 percent of their stock days, respectively. All members as a group posted net balances in the +200 to 200 share range (including zero balances) in 44.9 percent of the stock days in which any member participated. Individual member classes posted such balances somewhat more frequently; 54.6 percent for floor traders, 66.4 percent for odd-lot dealers, and 57.0 percent for members off floor." On a substantial number of occasions, however, members posted sizable net balances. Members as a whole, and each member class individually, had net balances in excess of 1,000 shares in very roughly 10 percent of the stock days in which each category traded. With the exception of odd-lot dealers, each member class posted balances in excess of 10,000 shares on several occasions. The nature and significance of member net balances are treated in greater detail in the parts on specialists, floor traders, and members off floor, to follow.

6. SUMMARY

Member purchases and sales as principals account for approximately 25 percent of all purchases and sales in the round-lot market of the NYSE. To a large extent this trading, particularly by specialists and odd-lot dealers, contributes to the efficient functioning of the market. At the same time, however, the potential conflicts of interest between these members and nonmember participants in the market, and the possible impact of member trading on stock activity, raise fundamental problems of exchange regulation. As a general background for the following parts of this chapter, which treat these problems in detail, this part has sketched the general characteristics of member trading, both for members as a whole and for the major classes of members specialists, odd-lot dealers, floor traders, and members off floor.

As measured by the number of stock days in which they participate, members do not seem to show a preference for stocks of any given price level. Within the stock days in which they do participate, however, there is a pronounced tendency for members to account for a greater percent of total trading volume in high-priced stock days than in low-priced stock days.

70 In this instance the fact that specialist data dominate the aggregate data for all members is particularly important. Although specialists trade in a stabilizing fashion (app. VI-A, chart 9 and table 9), members off floor tend to show consistent sale balances regardless of price movements (table VI-80) and floor traders tend to trade in a destabilizing fashion (table VI-71).

71 Specialist balances in the 200 to -200 range were not computed. However, in 55.7 percent of the stock days in which they traded, they posted net balances in the 300 to 200 share range.

Members participate in a greater number of stock days of wide price range than narrow price range, and in addition the volume of their trading tends to increase as the price range widens.

Most pronounced is a tendency for members to trade in a greater number of stock days of high volume than low volume. Within these stock days in which they trade, however, the volume of their trading (expressed as a percent of total stock day volume) does not appear to vary as a function of total stock day volume.

Finally, over the 3 weeks studied members as a group were generally buyers on balance on stock days of declining prices and sellers on balance on stock days of rising prices, and thereby exerted a stabilizing influence on price movements. As to this particular characteristic, however, the various types of members tend to be more dissimilar than similar. The group data are dominated by the trading of specialists, who tend to trade in a stabilizing fashion. Members off floor, on the other hand, tend to be sellers on balance regardless of price movements, while floor traders exhibit a destabilizing pattern of trading.

Because member trading accounts for a substantial percentage of total Exchange trading, and because it is engaged in by individuals responsible for operating a public securities market, it necessarily poses many basic problems in the areas of Exchange regulation and self-regulation. In several of the following parts of this chapter these problems are treated in detail.

D. SPECIALISTS

1. INTRODUCTION

Although centralized securities exchanges have been in existence for several centuries, the specialist system, as presently in effect on major American exchanges, is less than 100 years old. About a century ago the American exchanges adopted the continuous auction method of trading, which is responsible for the present specialist system. Under the continuous auction system, each issue is traded at one designated place on the floor called the "post." There are 19 such posts on the New York Stock Exchange (NYSE), 21 on the American Stock Exchange (Amex), 7 on the Midwest Stock Exchange (MSE), and 31 on the Los Angeles and San Francisco floors of the Pacific Coast Stock Exchange (PCSE). At each trading post are one or more exchange members who "specialize" in some or all of the issues traded at the particular post, and who are registered with their exchange as "specialists" in their particular securities. Their activities are circumscribed by section 11 of the Exchange Act and the rules of the different exchanges.

The specialist performs two basic functions with respect to the issues in which he specializes. As a broker, he holds and executes orders for the public (usually forwarded to him by other exchange members). As a dealer he is a "market maker" and trades for his own account in the securities in which he is registered.

The service that the specialist performs as broker derives from the nature of the continuous auction market and an exchange which trades a large number of issues. It is the basic obligation of a broker to execute a customer's order expeditiously when, according to its terms and under the rules and procedures of the market, the order is

capable of execution. Many investors use "limited price" orders specifying a price above which the customer will not buy or below which he will not sell. Until the market moves to the point set by the customer, such orders are not capable of execution. A floor broker cannot carry limited orders with him as he moves about the floor since he may be elsewhere as the limit is reached and may "miss the market." It is likewise not feasible to have floor brokers wait at a post for a limit to be reached since in some cases the market may never move to the limit, and in others it may take hours, days, or weeks until such orders can be executed. Under existing trading methods it is a practical solution for floor brokers to transmit limited orders to a single broker who stations himself at the post and acts as a central repository of such orders. The utility of this function has never been questioned.

The specialist who holds an order is a subagent 72 in a fiduciary relationship with his principal, the customer who originated the order. Thus, in the event of an erroneous execution a customer may hold both the specialist and his own broker liable for any damages. Section 11 of the Exchange Act prohibits a specialist from disclosing information regarding orders placed with him. In the alternative, a proviso grants authority to the exchanges or the Commission to require full disclosure of all orders which the specialist holds. The unexecuted public orders entrusted to the specialist for execution comprise what is known as the "book."

Section 11 of the Exchange Act also permits the specialist to act as a dealer, but his dealer transactions must be restricted "so far as practicable to those reasonably necessary to permit him to maintain a fair and orderly market." An Exchange rule reiterates this limitation; at the same time, as discussed below, specialists are encouraged to engage in dealer transactions in order to maintain a fair and orderly market. As a reflection of the specialists' obligation to maintain fair and orderly markets, their dealer participation extends fairly evenly over all types of stocks rather than being concentrated in particular stocks classified by price or volume (charts VI-1 to VI-4).

73

As of the middle of 1962 there were 360 specialists registered on the NYSE, of a total membership of 1,366; 159 specialists registered on the Amex, of a total membership of 499; 40 specialists on the MSE, of a total membership of 400; and 31 specialists on the PCSE, of a total membership of 160.

In 1961, NYSE specialists bought or sold as dealer 312,190,000 shares or about $12.7 billion worth of securities; this amounted to 29.3 percent of total round-lot volume. During the same period, specialists were involved as brokers in about 30 percent of round-lot volume." These figures indicate that the conduct of specialists directly affects the interests of a large proportion of investors and illustrate the specialists' importance in the auction market. But in addition to their volume of trading, no other class of exchange member is so intimately connected with the trading process and in so crucial a position to affect trading as to prices and as to manner and speed of execution of orders. Thus, the rules and practices defining the functions and conduct of the specialist business are of vital significance to the health of the entire auction market and affect all of those who deal in it.

72 Restatement of the Law of Agency (Second), sec. 5 (1958).

73 NYSE Guide, par. No. 2104.10.

74 See sec. 5, below.

In the staff report on the Amex, the specialist's crucial position was described as follows:

In his unique capacity the specialist stands at the heart of the Exchange market mechanism. He has intimate knowledge of the past market action of the stocks in which he specializes. He also has sole access to the specialist book showing outstanding orders both below and above the market, which affords him a great competitive advantage over the public. In addition, he exercises a significant influence on the public appraisal of a security, since he is the one who quotes the market. For all these reasons, it is a matter of tremendous importance in the maintenance of a fair and orderly market that a specialist's transactions as principal be only of such kinds and in such amounts as are consistent with his function of acting as broker at the vital center of the auction market.

The statutory scheme and the rules of the Exchange have attempted to establish a workable regulatory pattern whereby the specialist is permitted to trade for his own account in addition to acting as a broker. These provisions were designed to resolve the inherent conflict arising from the combination of functions by maintaining the fiduciary standards which are expected of a broker and yet permitting him to trade as a principal to maintain the continuity of a fair and orderly market.

In the course of the present Special Study of Securities Markets we intend to inquire further into the functioning of this regulatory pattern. *

* 75

The staff report on the Amex described "manifold and prolonged abuses by specialists" on that exchange. Because of this background, certain aspects of this investigation were directed toward determining whether similar patterns of conduct were present among NYSE specialists. No such patterns have been discovered. On the other hand, the very absence of major illegality under the present rules has served to highlight more subtle and complex problems concerning the activities of specialists. Most of this part is devoted to a discussion of these problems.

2. SCOPE AND METHODS OF STUDY

This part of chapter VI examines the functioning of a system which strives to reach compromises in three important respects: the first is between self-interest and fiduciary obligation; the second, between a completely free market and a market made "orderly" by the professional market maker; and the third, between a similarity of objectives and a great diversity in the activities of individual specialists and in the characteristics of individual securities traded.

The following discussion of specialists concentrates on the activity of NYSE specialists. But the basic organization of the specialist system of the Amex and the market characteristics of its stocks are such that the NYSE data apply to many of that exchange's specialists. Therefore, most of the general statements of this part are applicable to both the NYSE and the Amex, except as to matters associated with specific policies of the NYSE. Certain problems peculiar to the Amex system have already been covered in the Amex report. The specialist system on the regional exchanges is not parallel to that of the NYSE because of the dual trading system, limited volume, and other factors. Except where specifically noted, none of the discussion or conclusions of this part can be considered applicable to those exchanges.

Data for the study were obtained in various ways. A questionnaire EX-176 was sent to all NYSE specialists. Many files of the NYSE

75 SEC, "Staff Report on Organization, Management, and Regulation of Conduct of Members of the American Stock Exchange," p. 23 (1962) (hereafter "Amex report"). 76 A copy of this questionnaire appears in app. VI-B.

floor department were examined, and testimony was taken from 23 specialists, 2 other important floor members, and supervisory exchange officials.

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Questionnaire EX-1 asked for data on the specialist, his firm, and particular subjects selected for detailed study. These subjects included "stopping" stock, block transactions, "stop" orders, investment positions in issues in which the specialist is registered, types of orders accepted, and income and capital data.

Specialists were also requested to submit various statistical data on "stopped" stock for February 21, 1962, and on "stop-loss" orders for March 19 through March 30, 1962.78 Furthermore, all orders held by specialists at the close on February 16, 1962, and at the opening on February 19, 1962, were requested for 103 selected stocks; " these issues were selected to provide a cross section of stocks of high activity, low activity, and median activity.

79

Complete specialist trading data were requested for 3 selected weeks in 1961, those ending January 27, March 24, and June 16. During these weeks the Standard & Poor's "500" Stock Composite Index changed +1.28, -0.18, -1.48, respectively. The results of various studies of this data appear throughout this part and elsewhere in this chapter, and are referred to as the "3-week study."

Trading data covering the period of the May 1962 market break were also requested from specialists in 50 stocks. This included detailed trading data for May 28, 29, and 31 and weekly purchase and sale data for the period of September 1, 1961, to June 29, 1962.

The rules and policies of the NYSE governing the conduct and performance of specialists, together with various unpublished Exchange documents interpreting and supplementing these, have also been studied. Exchange files pertaining to specialists were examined for the period January 1, 1959, through August 1962. These files consist of the routine studies of all specialist firms performed by the floor department of the Exchange, and also contain customer complaints, disciplinary and quasi-disciplinary actions taken against specialists, and capital reports. Circulars and other memorandums circulated among specialists by the Exchange for the period January 1, 1957, through December 1962 were examined. The files of the Commission containing unpublished studies and correspondence between the Commission and the Exchange from 1934 to the present were also studied. The specialists invited to testify were selected in part on the basis of the answers to the questionnaire, and in part to include a cross section of specialists. However, most were affiliated with the larger specialist firms, and almost all of these were the senior partners of their units, with many years of experience as floor members on the Exchange. Investigatory visits were made to the offices of a few specialists to gather additional data or to confirm data previously accumulated. In addition, members of the staff spent time on the floor of the Exchange observing floor operations.

Data on stop orders were collected for a study of the subject conducted by the Division of Trading and Exchanges and are not included in this report. 78 See forms A and B of questionnaire EX-1 in app. VI-B.

See form C of questionnaire EX-1 in app. VI-B; the stocks are listed in app. VI-C.