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3. THE HISTORY OF THE SYSTEM AND THE REGULATORY PATTERN

a. History of the system

Until shortly after the Civil War the NYSE operated as a "call" market.80 Under the "call" system, an exchange official calls the names of particular stocks one or more times during the course of the day, and all brokers holding orders from their customers trade at that time. Even prior to the Civil War a "street" market characterized by continuous trading in NYSE issues had developed, and more volume was often accounted for there than at exchange calls. By 1869, the two markets had consolidated. Business at the calls had been decreasing and continued doing so, and the calls were finally discontinued a few years later.

Although the abandonment of the "call" system was the result of increased volume, the conversion of the Exchange to a continuous auction must have resulted in relatively thin trading markets. In a "call" market, brokers collect all orders for execution at the time the stock is reached on the list, and the price level is the result of the execution of all the orders which have arrived in the market over a period of time. On the other hand, in a continuous auction market, a market order is usually executed as soon as a willing party on the other side is found.

There appear to be no historical data showing how the problem of continuity was handled, if at all, between the adoption of the continuous auction market and the turn of the century. Likewise, the exact time that members first became specialists is unknown. By 1909, however, specialists were a significant enough factor on the Exchange to merit mention in the Hughes Committee Report.81 Still, the demarcation between specialists, commission brokers, and floor traders was apparently not yet fully established.82

The first specialists seem to have been primarily brokers,83 handling limited orders for other members. This appears to have been their most important function until at least the first decade of this century. This is not to say that specialists during this early period did not trade for their own accounts. Their trading, however, was probably similar to that of floor traders though concentrated in their own specialty stocks, with which they were most familiar.84

With the passage of time, floor brokers probably tended to give their limit orders to those among the many competing specialists who were

80 Unless otherwise noted, the material in this part is from Eames, "The New York Stock Exchange" (1894). 81 Report to Governor Hughes of the Governor's Committee on Speculation in Securities and Commodities. Reprinted in Van Antwerp, "The Stock Exchange From Within," p.

426 (1913).

82 Twentieth Century Fund, "The Securities Markets," p. 405 (1935).

83 This is confirmed by testimony of a leading specialist at the hearings which led to the Exchange Act:

"Mr. ADLER. Twenty-five years ago [about 1909] a trading specialist was more or less unknown. Over a period of the last 25 years, not only the desire of specialists to trade, but at the request of commission houses who are our customers, the trading specialist has come into being.

"CHAIRMAN. The primary function of a specialist is to act on commission for another

house.

"Mr. ADLER. Yes."

Hearings on S. Res. 84, S. Res. 56, and S. Res. 97 before the Senate Committee on Banking and Currency, 73d Cong., 1st sess., pp. 6792-6793 (1934) (hereafter "Hearings on Stock Exchange Practices").

See sec. 6.e (1), below.

willing to deal as principal when that became necessary in order to give a broker a "good" execution--generally an execution close to the last sale.85 Indeed, the cornerstone of the conventional argument that the specialist has an economic incentive to deal for his own account is that, by providing a liquid market and preventing unreasonable price fluctuations, the specialist will be favored with increased commission business.86

Whether as a result of the pressure of competition or other factors, there did arise so-called "dealer" specialists. Finally, in about 1939 the Exchange began an affirmative program to compel specialists to become dealers, possibly in response to the needs of commission houses faced with difficulty in obtaining good executions in that period of low volume. As a major part of that program, the first specialist capital requirement was instituted in 1939.87 Although this requirement is somewhat similar to the one in effect now, which is considered "nominal," vigorous enforcement of the rule in the early days led to the demise of a number of specialist firms. Also at about this time, the Exchange withdrew the registration of some specialist firms for their failure to deal adequately. A present reflection of this policy is that a specialist unit with a good record as dealer is more likely to have newly listed issues allocated to it. Even in recent years there has been a steady decrease in the number of separate specialist units, from 136 as of January 2, 1957, to 109 as of January 2, 1963 (table VI-3).88 Furthermore, the Exchange since 1953 has had a policy of not allocating new stocks to one-member specialist firms, and does not allow any single-member specialist ventures to be started. It seems fairly apparent that the existing one-man firms (and some other small ones) are holdovers from the time when specialists were primarily brokers.

As the dealer specialist emerged, a drastic decline in competing specialists has occurred. In 1933, there were 466 stocks with competing specialists, in 1957, 228 stocks, and today only 37. The decline has been steady and, if anything, has accelerated; as recently as 1960 there were 137 stocks with competing specialists (table VI-3). Historically, competition occurred in stocks where the existing specialist's service was not satisfactory or where the volume was heavy.82 At present, competition is unsatisfactory for several reasons. Commission firms are often confused as to who is quoting the market in active stocks. The commission firms do not shop for the best service but

8 The price of execution is always important to brokers, especially in actively traded issues. A customer who places an order of even moderate size in an inactive issue knows he must wait a reasonable time for an execution or may have to trade at a discount from the last sale. But an investor in a well-known issue would be surprised if his order of moderate size was transacted at a discount. For a more complete discussion of this aspect

of the dealer function, see sec. 6.a, below.

86 Hearings on H.J. Res. 438 Before a Subcommittee of the House Committee on Interstate and Foreign Commerce, 87th Cong. 1st sess., p. 116 (1961) (hereafter Hearings on H.J. Res. 438). SEC, Report on the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker, p. 40 (1936) (hereafter "Segregation Report").

This argument loses force with the present scarcity of competing specialists. At present for the vast majority of stocks, there is only one specialist to whom a commission broker can give a limit order.

67 This required specialists to have $10,000 in liquid assets, or liquid assets sufficient to purchase 100 shares of every 100-share-unit issue in which they specialized, whichever was greater. See sec. 4.c, below.

In 1933, there were 105 individual specialists; currently there are only 21 (tables VI-3 and VI.c). At one time, commission firms invited specialists to start competing books.

often give each competitor half their brokerage business. In addition, neither competitor accepts full market-making responsibilities, thus adding to the Exchange's regulatory problems.

The emergence of the dealer specialist and the decline of competing specialists are associated in time with a decrease in the average total volume of trading per issue and also in the concentration of volume in

Percent of Total Reported

Chart VI-a

New York Stock Exchange

CUMULATIVE PERCENTAGE DISTRIBUTION OF TOTAL REPORTED ROUND-LOT VOLUME
1928 and 1961

Round-Lot Volume

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the most active stocks. Specialists have testified that the changes in volume characteristics from the 1920's to the present has had an effect on their functions. As a rough measure of this assertion, the study analyzed volume data for two bull market years, 1928 and 1961. In 1928, the reported stock volume was 930,893,276 shares and in 1961, a year of relatively comparable volume, 1,021,264,589 shares, a difference

90 Similar allocation of business to the odd-lot dealer is discussed in pt. E.3.d of this chapter.

of 10 percent. However, in 1928, 1,176 issues were listed on the Exchange, while in 1961 there were 1,541. Thus, there was an annual average volume per stock of about 792,000 shares in 1928 and 663,000 in 1961 or 16 percent less. Furthermore, in 1928, 44 percent of the volume was accounted for by the 50 most active stocks, while in 1961 the 50 most active accounted for only 25 percent of volume. In light of the total volume figures, the change in concentration means that in the most active stocks, public markets were thinner in 1961. The dealer function, which is important in assuring executions close to the last sale, has accordingly received increasing emphasis.

Thinner markets in active stocks have also led to thinner books with less opportunity for specialists to earn brokerage in their stocks.92 This decline in brokerage income has probably been another cause in the decline in competing specialists. A good example of this may be found in the fact that in 1928 volume in U.S. Steel was 19,809,700 shares, and at about that time, there were eight competing specialists in the stock. In 1961, when volume in the stock was 3,345,400 shares, the number of competing specialists had declined to two.93

Perhaps the most dramatic indication in the shift of emphasis from broker to dealer can be found in the comparison of the testimony given by two Exchange presidents, almost 30 years apart. When the then president of the Exchange testified in the course of Senate hearings in 1933, the first reference to specialists was as follows:

Senator BROOKHART. What is a specialist?

Mr. WHITNEY. A specialist is one who executes orders for other brokers on the Exchange in a particular stock."

In 1961, NYSE President G. Keith Funston was asked a somewhat similar question and replied:

[T]he essence of being a specialist is dealing for his own account. That is being the specialist."

b. The regulatory pattern

The specialist system has had its critics almost from its inception. Criticism has historically focused on the conflict of interest between the broker and dealer functions and the possibilities of manipulation inherent in the specialist's market position. This section deals with the historical development of the regulatory pattern as connected with these problems.

In 1909, the Hughes committee noted the receipt of complaints that specialists who dealt in inactive securities bought and sold for their own account while acting as brokers. The report stated that such dealings, without the principal's consent, are illegal. The report also noted that "the practice of specialists in buying and selling for their own account often serves to create a market where otherwise one would not exist." Because of this latter factor the committee was against the segregation of the broker and dealer functions, "notwith

91 The top 5 percent of all stocks in 1928 accounted for 40 percent of Exchange volume, while in 1961 the top 5 percent accounted for 33 percent of the volume (table VI-4 and chart VI-a).

92 For example, the specialist in Transamerica stated that even after making rough adjustments for splits, etc., his brokerage in this issue is now only about one-third as great as it was in 1929.

93 In 1928, U.S. Steel was the third most active stock on the NYSE. Its 1928 volume of 19,809,700 shares was over 9 million shares greater than the stock that was the volume leader in 1961. In 1961 U.S. Steel was the forty-second most active stock on the NYSE. 94 Hearings on Stock Exchange Practices, at p. 254.

Hearings on H.J. Res. 438, at p. 116.

standing that the system of dealing in specialties is subject to abuses." 96

In 1910, probably in response to the Hughes committee criticism, the Exchange adopted a rule prohibiting specialists from trading with the book, i.e., dealing as principal with a customer whose order the specialist holds as agent, without the customer's consent.

The next period of criticism came about 10 years later and still focused upon the conflict of interest between broker and dealer functions. In 1922, criticism by member firms and the public led the Exchange to appoint a committee to suggest improvements." The most significant change resulting from the committee's study was a modification of the 1910 rule so as to permit specialists to trade with their book "provided the price at which the stock is taken or supplied is justified by the conditions of the market, and provided that the member *** giving the order*** having been notified as soon as possible, accepts the trade and reports it." 98

Renewed criticism of the specialist system came a decade later, but now the main focus was on manipulation rather than conflict of interest. The Pecora investigation of 1934 followed the collapse of the bull market of the twenties. A significant portion of the testimony concerned the activities of specialists as participants in the pools and other manipulative activities that had characterized the previous period of speculation. The Exchange Act was the result of that investigation. The provisions of the act relating directly to specialists are in section 11, as follows:

(a) The Commission shall prescribe such rules and regulations as it deems necessary or appropriate in the public interest or for the protection of investors (1) to regulate or prevent floor trading by members of national securities exchanges * It shall be unlawful for a member to effect any transaction in a security in contravention of such rules and regulations, but such rules and regulations may make such exemptions *** within the limitations of subsection (b) of this section, for transactions by * specialists, as the Commission may deem necessary or appropriate in the public interest or for the protection of investors.

(b) When not in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, the rules of a national securities exchange may permit ** a member to be registered as a specialist. If under the rules and regulations of the Commission a specialist is permitted to act as a dealer, or is limited to acting as a dealer, such rules and regulations shall restrict his dealings so far as practicable to those reasonably necessary to permit him to maintain a fair and orderly market. *** It shall be unlawful for a specialist or an official of the exchange to disclose information in regard to orders placed with such specialist which is not available to all members of the exchange, to any person other than an official of the exchange, a representative of the Commission, or a specialist who may be acting for such specialist; but the Commission shall have power to require disclosure to all members of the exchange of all orders placed with specialists, under such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. It shall also be unlawful for a specialist acting as a broker to effect on the exchange any transaction except upon a market or limited price order.

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(e) The Commission is directed to make a study of the feasibility and advisability of the complete segregation of the functions of dealer and broker, and to report the results of its study and its recommendations to the Congress on or before January 3, 1936.

Van Antwerp, "The Stock Exchange From Within," p. 426 (1913).

"The New York Stock Exchange, Report of the President, May 1, 1921-May 1, 1923." "The New York Stock Exchange, Report of the President, May 1, 1921-May 1, 1923." The rule reached its present form in 1932. See sec. 7.a, below.

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