importance. Many of these investors tend to hold their positions, and when they do trade, their orders are ordinarily not given to the specialist but are handled by brokers in the crowd.

c. Predictive value of the book

The specialist's book has an importance beyond that of a mere repository of unexecuted agency orders. It serves as an indicator of public interest in a particular security. For example, a book containing many orders reasonably close to the market indicates that, at the time, the stock is an active one of wide interest. On the other hand, a light book may indicate that a stock is less active, or that if active, it may be volatile in character.

A much-argued point has been whether the number of buy-and-sell orders contained on the book is an indicator of immediately forthcoming market trends. At the time of the Pecora hearings some specialists argued that the book was almost valueless from this point of view.146 The same argument was made in 1935, when the Commission had under consideration a rule which would have required complete disclosure of the book, and the same point was reiterated during the Segregation Study. In fact, it was argued that the contents of the book are apt to be misleading since many orders are not in the book-some are held by floor brokers and others are in brokerage offices and not yet transmitted to the floor.

Nevertheless, it seems clear that in certain instances the book is an important indicator. A book that has a great many sell-stop orders suggests that the stock will suffer a quick decline when these orders are reached. In addition, a large number of limit orders immediately below or above the market may indicate that, in the very short run, there is a floor or ceiling to the stock's price.

Some specialists testified that the trend of the market is indicated by the orders on the book-that a book which contains many sell orders is characteristic of a stock which will increase in price, while a book containing many buy orders indicates that the price will decline.147 One specialist stated that this theory has greater validity when limit orders to sell are filling in after a stock has reached a low or limit orders to buy are entered when a stock has just gone through a sharp rally.

d. Disclosure of the book

In view of the importance of the information contained in the specialist's book and the fiduciary relationship between the specialist and his customer,148 it is not surprising that provisions limiting disclosure of the book were included in section 11(b) of the Exchange Act.149 The House committee report on the Exchange Act stated:

No issue has been more disputed than that centering around the functions of the specialist. *** It is true that some of the worst evils associated with the

146 See, e.g., "Hearings on Stock Exchange Practice," at pp. 511 and 512.

147 It might be thought, at first consideration, that a book heavy on the sell side would indicate selling pressure and a book heavy on the buy side would indicate buying power, which would be the opposite of what the testimony indicates. However, it has been suggested that sophisticated investors place limited buy orders below the market when they are anticipating a price decrease and sell orders above the market when they are anticipating an increase.

148 Even though the predictive value of the book may be debatable, it is obvious that the presence of particular orders in specific stocks could be useful knowledge, the disclosure of which could be detrimental to the interest of the particular customers involved.

149 NYSE rule 115 is the Exchange's interpretation of this prohibition.

specialist have centered around their participation in pools, but there are inherent difficulties in the situation where under normal circumstances the available orders are known to the specialist only-and perhaps his favored friends— and not to everyone dealing in the security involved.150

Since the specialist's book is a working tool it is not kept physically hidden. In the course of active trading, other floor members probably catch an occasional glimpse of the book. The Exchange recognizes this, and in a circular dated November 16, 1961, sent to all specialists, stated that the rule prohibiting specialists from revealing the book also prohibits disclosure of the book's contents by the physical manner in which it is handled.

The rule prohibiting the book's disclosure has not been interpreted by the Exchange to prohibit a specialist from telling an inquiring broker at which price or prices a block of stock could be purchased or sold. Specialists have testified that, when informing a broker of a "cleanup" price for a block, they do not tell him the number of shares at each eighth but rather the lowest price the customer will receive. The broker does not know whether the specialist himself may be interposing a bid, and thus cannot infer the state of the book.

With respect to disclosure of the size of the best bid or offer, an interpretation of one of the Exchange rules states: "Specialists should state the full size of the offer except in instances in which they believe the proper exercise of the brokerage function makes it inadvisable to do so." 151 The floor governors, in an interpretation, decided that when the size of the prevailing bid or offer is requested, the full size of accumulated orders at the bid or offer price should be given, but that a specialist would be justified in withholding information if the bid or offer were part of a single substantial order and full disclosure would be detrimental to the interests of the customer.

Questionnaire EX-1 asked whether specialists thought that the handling of block orders on the Exchange would be facilitated if all members were entitled to disclosure of agency orders on the book. Only 2 specialists answered yes, while 354 answered in the negative. Most specialists responded that disclosure of orders on their books would be unwise because it would permit nonmembers to trade against the orders on the book. They also believed that such disclosure violated their fiduciary obligations. Two specialists answered as follows: This would create an advantage for the off-the-floor trading or negotiated market versus the auction market on the floor of the Exchange.

If the public became aware of unusually large orders the tendency very likely would be for the public to want to be on the same side of the block. The execution of the block would be more difficult, therefore, and the fluctuations accentuated.

The other side of the coin is, of course, that the specialist is in the same position as others who might seek to use knowledge of the contents of the book for their own profit, except insofar as his activities are circumscribed by rules.

Thus, in executing his brokerage functions, the specialist has a powerful tool, available to him only, giving him insight into the pos

150 H.R. 1383, 73d Cong., 2d sess., pp. 14-15 (1934).

151 NYSE Guide, par. No. 2110.27. (This interpretation is apparently misplaced as it appears as supplementary material to a rule pertaining to floor trading.)

sible course of the market. The justification for the special treatment can lie only in the need for such information for the most effective conduct of his dealer activities, which, as has been indicated, provide the basis for the fulfillment of his responsibilities to maintain a fair and orderly market.

a. Market continuity

6. THE DEALER FUNCTION

The NYSE provides a market in which every traded security can be bought or sold at any time during normal trading hours. The price of the transaction ought to bear a reasonable relationship to the immediately preceding one. It has been the consistent view of the Exchange, expressed on many occasions and under different circumstances, that liquidity and continuity are the prime indicia of the quality of a market. Exchange President Funston has stated:

The sole purpose of a modern marketplace is to provide the public with an efficient and dependable mechanism through which securities can be bought and sold. *** This means, ideally, that every buyer and seller should be able to find his opposite number quickly, and at a price reasonably close to the last sale. 152

Some years ago the Exchange explained the premium placed on liquidity and continuity as follows:

If a seller came into the market and found no buyer who was willing to purchase at or near the value of the security as established by the last sale, the seller would have but two alternatives. He could either withdraw from the market and wait until some buyer entered the market who was willing to purchase his security at a fair price, or he could accept the bid then in the market even though such bid were far below the last sale and below what the seller considered to be the fair value for his security.

If a loan is secured by a particular stock and the lending bank sees even a single sale of that stock several points below the loan value it has placed on it, the bank, of necessity, must ask for further collateral or liquidate the loan, and this liquidation may temporarily further depress the price of his stock and thereby cause others to liquidate, even though an hour or day later purchasers may come in and pay far more for the security than the price caused by the temporary disparity between supply and demand.

The NYSE considers that for a successful auction market a stock should trade at least 100,000 shares a year, or an average of 400 shares a day. In 1961, the issue of median activity (of all common and preferred stocks) traded 292,300 shares during the year, or approximately 1,200 shares a day. For the 3-week study period as a whole, 50 percent of the common stocks which traded on 1 or more days traded 1,800 shares or less per day (chart VI-3).

Based on the NYSE standard of minimum activity there would be an average of only four round-lot transactions in the market during the 52 hours of trading, hardly enough to provide the basis for a continuous auction. But even with respect to those issues which have a more substantial volume it would be happenstance if public buyers and sellers all were to come into the market at the same time during the day or even at close to the same time. For example, during the 3 weeks studied, a stock was in the top quarter of activity if it traded 5,000 shares per day (chart VI-3); for such a stock, there would be

152 Funston, letter, Harv. Bus. Rev., September-October 1962, p. 8.

only 50 round lots traded over a 52-hour period. Moreover, it would be highly coincidental if there were exactly 50 buyers and 50 sellers, each of whom desired to buy or sell 1 round lot, in any one day. In fact, during the 3-week study, 50 percent of the cases had less than 15 transactions per day (chart VI-4). On any given day orders come in different sizes; there may be an institutional order on one side of the market for several thousand shares, and only a few single round lots on the other side. This means that there are not enough public participants at any one time to assure, in a continuous auction market, that buy and sell orders will be so neatly matched as to provide a true reflection of value in the classic market sense.

Specialist trading serves as a substitute for having all orders entered during a continuous trading period matched against one another. This is what is meant by the function of "evening out temporary disparities between supply and demand." 153 i.e., the failure of the small number of participants in the market at any one time to reflect a true composite opinion as to price. The NYSE takes the consistent position that it is the specialist's dealer function that gives the market liquidity and continuity. The president of the Exchange stated:

[I]f specialists did not fill gaps in public supply and demand, the result would be chaotic markets ***. Individual stocks would reach new highs one day and new lows the next."

154

On another occasion the Exchange stated:

The New York Stock Exchange believes that securities exchanges should provide fair and orderly markets in which there is a reasonable continuity of prices, and it believes that without the specialist system, or some yet undiscovered substitute, securities markets cannot be fair and orderly.

Funston also testified that any undue tampering with the specialist system would "ruin the auction market." 155 Given the thin public markets, there is obviously some merit to this argument. The existing specialist system results, in most cases, in a reasonable approximation of what a true continuous auction market would be if there were sufficient participants at one time.

However, it has been argued that the specialist's intervention prevents some public investors from gaining a particularly good bargain. For example, the public market as represented by the book may be 33 bid, offered at 35, with the last sale at 35. If a market order to sell arrives, and if the specialist were not to enter a bid for his own account at a price over 33, some member of the public would be able to buy at 33. Thus, should the specialist bid over 33, he deprives the potential buyer of a bargain in buying from a willing seller, and interferes with the operation of a free market. The question of whether the potential buyer, under the then prevailing market conditions, was entitled to an execution at 33, cannot be answered without considering the situation from the seller's viewpoint. Was the public bid of 33 or the specialist's bid of say 3434 a more reasonable price to the seller? The last price was 35 and as far as the seller is concerned (and assuming no extrinsic corporate or general market development), it seems fairly clear that 3434 is a more reasonable price than 33, especially if it is borne in mind that without the intervention of the specialist, the next

153 See sec. 6.b, below.

154 Funston, letter, Harv. Bus. Rev., September-October 1962, p. 8. 155 "Hearings on H.J. Res. 438," at p. 116.

public order to buy would probably be executed at 35, resulting in three consecutive transactions at 35, 33, and 35. Under such circumstances it would seem that the buyer bidding 33 is not unreasonably deprived of his bargain if the effect of the specialist's intervention was that the seller received a price more nearly in line with the preceding and succeeding transactions, such as in a sequence of 35, 3434, and 35. b. Market continuity and the current regulatory pattern

Since the Exchange considers continuity and liquidity of vital significance,156 and in light of the volume data presented above,157 it is not surprising that the exchange has increasingly emphasized the dealer activities of the specialist. Nevertheless, many important questions of policy and practice arise from this emphasis.

In section 3.b, above, the discussion of the regulatory history of the specialist system was carried through the Saperstein Interpretation of 1937. The interpretation, as supplemented by exchange rules and policies, still remains the governing regulatory pattern. As was also noted, the Saperstein Interpretation was preceded by about a year by the Commission's Segregation Report. In fact, the interpretation embodies the concepts advanced in the Segregation Report, and thus any description of the present regulatory pattern should start with the recommendations made in that report.

On June 20, 1936, the Commission transmitted its Segregation Report to Congress stating:

*** pending the acquisition of further knowledge, emphasis should be placed on: (1) Insistence upon the observance of rules against unjustified trading by the specialist. *** Trading for his own account should meet an affirmative proof of justification and is not to be condoned simply because its undesirability cannot be established in each case. (2) The development of appropriate restrictions governing the conditions under which the specialist may trade with his book,158

The report suggested three possible rules to regulate specialist dealer activities, 159 Two of these would have prevented a specialist from trading with the book in a way that would have the effect of widening the quoted market; i.e., "cleaning up the book," thus creating or accentuating price movements: when a specialist trades with the book he often "reaches" for a bid or offer which is apt to establish a new price level, whereas if he waits for someone else to trade with him, he is less likely to establish a new level. For example, the quote may be 50 bid, offered at 51, with the last sale at 50% and with the specialist as broker bidding for 200 shares at 50 for the book. If the specialist sells 100 shares for his own account, to the book at 50, he creates a new price; if he "cleans up the book" by selling it 200 shares, the next bid may be at 4912, and thus he has widened the quote.160 The third proposal would have prevented the specialist from trading with the book at prices that would establish new highs or lows for the day, thus preventing the specialist from stimulating public speculation by his own trades.

156 In fact, the Exchange encourages issuers to split their stocks to bring prices to favorable levels from the viewpoint of liquidity.

157 See sec. 3.a. above, which points out that volume in the most active stocks has diminished over the last 30 years.

155 Segregation Report, at p. 111.

159 Ibid.

160 By preventing the specialist from dealing with the book in these situations, these proposals would also have had the effect of ameliorating the conflict of interest problems which exist when the specialist trades with his own customers. See sec. 7.a, below.