The Saperstein Interpretation did not adopt these proposals as rules, accepting the arguments advanced by the NYSE that hard and fast rules governing a specialist's conduct could not be developed since a specialist's transactions "must be judged in relation to constantly changing market conditions." The most important part of the Saperstein Interpretation states: I wish first to emphasize that compliance with the rule 181 cannot be evidenced by a mere showing that a transaction by a specialist for his own account had no undesirable effect, or even no discernible effect upon the market. The phrasing of the rule leaves no doubt that it prohibits all transactions for the account of a specialist, excepting only such transactions as are properly a part of a course of dealings reasonably necessary to permit the specialist to maintain a fair and orderly market, or to act as an odd-lot dealer. In my opinion, therefore each transaction by a specialist for his own account must meet the test of reasonable necessity. The Interpretation goes on to set forth standards of performance derived from the general rule confining specialist transactions to those reasonably necessary to maintain a fair and orderly market. Transactions necessary to maintain a fair and orderly market were characterized as those which were "reasonably calculated to contribute to the maintenance of price continuity and to minimize the effects of temporary disparity between supply and demand." A broad exception was created by permitting a transaction to be justified not only by existing market conditions but also by anticipated market conditions, in other words, permitting specialists to position themselves. through trading in order to service the market if the trend changes." This exception materially increases the already subjective nature of the regulation of specialist trading. 162 After its injunction against unnecessary dealing, the Interpretation set forth three types of "transactions" effected by a specialist in taking or increasing a position which tend to have a detrimental effect upon the market and are therefore ordinarily unjustifiable.163 The first was a purchase above the price of the last preceding transaction. The sec ond was a purchase of all or substantially the stock offered on the book at the last preceding price. The third was supplying all or substantially all of the stock bid for on the book at the last sale price. The latter two rules were directed against "cleaning up the book." It was also pointed out that specialist transactions having similar market results, although not effected with the book, would generally be precluded.164 Until the Amex report, the Saperstein Interpretation was the last Commission pronouncement concerning specialists. In the intervening years implementation of the general policies and specific recommendations set forth in the Saperstein Interpretation was under 161 The reference is to what is now NYSE rule 104, which then read as follows: "No specialist shall effect on the Exchange purchases or sales of any security in which such specialist is registered, for any account in which he, or the firm of which he is a partner, or any partner of such firm, is directly or indirectly interested, unless such dealings are reasonably necessary to permit such specialist to maintain a fair and orderly market, or to act as an odd-lot dealer in such security." 162 This would ordinarily mean that if a specialist anticipated that the price of the stock was going to rise and that he would have to supply stock at higher prices he could accumulate a long position (even if his purchases do not contribute to price continuity or to minimizing disparities between supply and demand). 163 The transactions referred to are similar to those which would have been prevented by the rule proposals of the Segregation Report, but they are not flatly prohibited. 154 These prohibited transactions mean, in effect, that specialists cannot engage in positioning activities when such activities are not only unnecessary to provide market continuity but may create or accentuate price movements. taken by the exchanges. The NYSE restated the principal contents of the Saperstein Interpretation as interpretative material to its specialist rules,165 and evolved a series of tests to determine compliance with the rules.166 The present tests form the core of the Exchange's system for surveillance of specialists. 167 For each unit, examination is made of all transactions during a 2-week period (selected on a surprise basis) in each calendar quarter. The basic tool of specialist surveillance is Exchange Form 81,16s which calls for information as to date, time, number of shares bought or sold, price, tick,169 and daily opening position. Summaries of the data shown in the forms are then prepared so as to show results in three basic respects: the percentage of specialist dealer participation, the "stabilization" percentage, and the carryover position from day to day.17 The first test simply measures the degree to which the specialist unit has participated as a dealer in each of its stocks. The next, the "stabilization" test, measures each specialist purchase and sale against the previous transaction in the same issue. This test is a transactional one which, in light of the immediately preceding transaction, assigns each specialist trade to a "stabilizing" or "destabilizing" category. The third test, involving overnight positions, aggregates the unit's positions and shows the number of days that the overnight position fell into certain ranges. Each specialist unit is given a summary four times a year setting forth its "stabilization" and participation percentages and comparing them with the average percentage of all units studied during the same period. The Exchange's floor department supplements these routine studies with more elaborate studies. These, of which there were more than 4,000 in the past year, actually reconstruct the market for the period under examination.11 Market reconstructions are made in several situations, some arising from the routine 2-week studies, others from complaints by customers, member firms or issuers, and yet others from the Exchange's "stock watch" procedure.172 The Special Study's analysis of many of these studies leads to the conclusion that it is difficult to perceive any objective standards which are applied in determining whether a specialist has performed within the rules. Moreover, in almost all cases the studies result in no more than a generalized warning to the specialist to improve his per 185 This material now appears following NYSE rule 104, the basic specialist rule, which prohibits all transactions except those reasonably necessary to maintain a fair and orderly market. The Exchange's restatement of the Saperstein Interpretation is somewhat different from the original document. The most significant difference is that while the Saperstein Interpretation specically states that the transactions are not permissible merely because they have no market impact, the restatement expresses the concept in more general terms. Also, the Interpretation is prohibitory in tone while the Exchange restatement is admonitory in tone. Since the guidelines set forth are general, the difference in emphasis is important. 166 These tests seem to have been formulated around 1940. 167 NYSE surveillance of specialists is discussed in ch. XII. The present surveillance system of the Amex is similar to that of the NYSE. 168 A copy of this form appears in app. VI-E. 169 See sec. 6.d, below. 170 See app. VI-F. 171 This is an extremely complex task under present procedures. The Exchange gets tape time of transactions from one source; volume of each transaction from another; quotes from a third; daily volume from a fourth; member participation from two other sources and in some cases, the book is reconstructed (see sec. 5.b, above, discussing the difficulties involved in reconstructing the book). The Exchange's proposed automation will simplify many, but not all, of these procedures. 172 The "stock watch" procedure is discussed more fully in ch. XII. formance in a specific area. 173 Final conclusions on the adequacy of the routine tests and the supplementary studies cannot be arrived at, however, without reviewing in some detail the actual working of the specialist system and considering the motives that are likely to be involved in particular activities. c. Economics of the dealer function A substantial portion of specialists' income derives from their activities as dealers.174 This portion comes from the "jobber's turn," the profits which arise from being a professional dealer, and from selling inventory which has appreciated. The dealer's profit is quite similar to the profit that any middleman realizes when he buys low and sells high. The public investor using market orders is most likely to execute a buy order at the offer side of the market, while a market sell order is normally executed at the bid.175 In contrast to the public investor, the specialist usually buys at his own bid and sells at his own offer. To take a simplified example, a specalist is quoting both sides of the market for his own account, bidding 412 and offering at 42; two public market orders arrive in sequence, the first to sell and the second to buy. The first investor would ordinarily sell to the specialist at 412, increasing the specialist's position by 100 shares and the second investor would buy from the specialist at the offer of 42. The specialist would thus have a 2-point profit. 176 That this is a profitable process is indicated by an analysis of the 3-week trading data. The analysis, which covered 25 stocks, disregarded any transaction in which the specialist did not participate and considered only the specialist's transaction in relation to his own previous principal transaction on the opposite side. The examination measured the number of transactions in which the specialist sold above his previous purchase or bought below his previous sale,177 by various differences in price. Questions of inventory appreciation aside, a specialist's sale above his previous purchase or purchase below his previous sale may be considered a potential source of profit, whereas transactions on the opposite side present potential losses. The analysis indicated that specialists' transactions in these 25 stocks were potentially profitable 87.9 percent of the time and potentially unprofitable 6.6 percent of the time; 5.5 percent of the transactions were effected at no change from the previous transaction (table VI-23).178 This topic is more fully developed in ch. XII. 174 See sec. 4.b, above. 175 Most specialists believe that with a market order the broker is "held to the tape," i.e., to get the customer the best existing bid or offer. See the discussion in sec. 5.a, above. 176 If the two brokers representing the buyer and seller happened to arrive at the post at the same time they might arrange a trade at 41% thereby eliminating the "jobber's turn.' 177 For example, if the specialist transactions were a purchase at 35, a sale at 354. a purchase at 35%, he would have sold above his previous purchase and purchased beneath his previous sale. These are potentially profitable transactions. Potentially unprofitable transactions are those where the specialist purchased at a price above his previous sale or sold at a price below his previous purchase; for example, sale at 43, purchase at 43%. sales at 434. The transactions are termed "potentially" profitable or unprofitable because no attempt to compute actual profit was made since the size of transactions was ignored. 178 When the purchase and sale are at the same price, the specialist suffers a net loss because of the clearing expenses and transfer taxes that he must pay. A closer examination follows: TABLE VI-e.-NYSE specialists' potentially profitable transactions in 25 selected The results were unaffected by whether the stock increased or decreased in price during the period studied. On the other hand it was found that those stocks with proportionately more transactions (taking into account all participants) at variations of 14 point and over generally had a greater proportion of specialist transactions that were potentially profitable by 14 point and over (table VI-24). Thus, the specialist has an economic motive to quote wide spreads in his stocks. It was also found that there were 318 instances (including only situations involving 500 shares or more) in which the specialist purchased and sold the same number of shares during the course of a day. All but 28 of these resulted in profits for the day. The median profit earned was $0.31 a share and almost two-thirds of all profitable situations resulted in profits between $0.11 and $0.50 a share (table VI-25). Finally, the testimony of several specialists confirmed that the process of a purchasing at the bid and selling at the offer is probably the most significant source of the dealer profits. One stated with respect to specialists' activities as middlemen: [L]et's take a firm like Merrill Lynch, one minute they might have a buy order and the next a sell order. He purchases from the specialist and sells to the specialist subsequently. Very often, he would say, "If I only waited a minute I could have [crossed the orders] myself." The amount of this gross trading profit or "jobber's turn" per share traded may be roughly calculated. Total trading profits in 1959 and 1960 179 were $37,005,000 and the number of shares purchased by specialists was 246,276,000; 180 the resulting average profit per share was 15 cents.181 Viewed another way, this 15 cents per share may be regarded as the fee or service charge, to buyers and sellers using market orders, for price continuity and liquidity. Had these investors met through a medium which did not insure "instant" liquidity, and had 179 See sec. 4.b., above. 180 Total specialist sales in 1959 and 1960 were 246,313,000 shares. The number of specialists' completed transactions (i.e., those in which the specialist bought and sold) is represented by the lower figure, in this case, the purchase figure. 181 However, it should not be overlooked that aside from the "jobber's turn" specialists may profit from inventory appreciation or lose from inventory depreciation. Specialists who are bullish may deliberately allow their positions to accumulate, may acquire a posttion through the purchase of a block, or may purchase stock by taking offered stock. Carrying an inventory involves greater risks than intraday trading, but also the possibility of greater profit (or loss) than the "jobber's turn." It is interesting to note that the spe cialist unit which carries the largest positions had the largest dealer profit in 1959 and the largest dealer loss in 1960. they been forced to wait for a party on the other side, it may be assumed that the 15 cents would be divided, the buyer paying 7.5 cents less and the seller receiving 7.5 cents more per share. In the course of earning this profit, the specialists maintain a low inventory. The data show that viewed for almost any period of time, specialist purchases and sales are almost in balance. For example, in the period of the 3-week study specialists purchased 9,895,440 shares and sold 9,577,090 shares, or a difference of 3.3 percent between shares purchased and shares sold. Breaking this down weekly, the percentage differences are: This is not surprising in view of the specialist's function in providing market continuity since, as just pointed out, the specialist buys from one investor and sells to another who comes to the market later. It appears from daily transactional data in particular stocks that buyers and sellers are nearly in balance in many stocks. Thus, on a daily basis for the same 3 weeks, specialists' net purchase and sale balances (i.e., the difference between their purchases and sales) were 200 shares or less in at least 43 percent of the "stock-days" 182 in which they participated (app. VI-A, table 9 and chart 9). Also the daily purchase and sale balance is usually small when compared with their total purchases and sales (table VI-26). It also appears that the volume of specialists' trading is quite high in relation to their inventory. For example, on one sample day, June 16, 1961, specialists had an aggregate long and short position of 3,229,556 shares. If long-term investment positions 183 are substracted from the total inventory the resulting figure becomes 2,338,823 shares.18 On the same day, specialists sold 473,460 shares, or about 20 percent of their inventory. This also seems to indicate that a major source of trading profit is intraday trading. Many of the problems associated with the dealer function arise from the normal profit pattern just described. Some of these stem from activity by the specialist to adjust his trading to maximize the operation of this profit pattern. In doing so, he tends to avoid situations where this pattern is not operable and/or where there is substantial 18 The "stock day" concept is analogous to the man-hour or man-day concepts utilized in economic statistics. Thus, just as 10 man-days of labor may represent the work of 10 men on 1 day, 2 men on each of 5 days, etc., 10 "stock days" may represent 10 stocks traded on 1 day, 2 stocks traded on each of 5 days, etc. That is, any stock which trades on more than 1 day is counted as one for each day it trades; e.g., General Motors trading on 3 days during a period under study would be counted as 3 stock-days. If 900 stocks are traded on the Exchange on Monday, 1,100 on Tuesday, 1,050 on Wednesday, 950 on Thursday, and 1,100 on Friday, the total number of "stock days" for the week would be 5,100. The primary merit of the "stock day" approach is that it allows a study, by days, of all trading over the period studied, but at the same time breaks down this trading according to the daily performance of each stock. Although stocks cannot be identified by name, the characteristics of each stock for each day it trades (its price, price range, and volume, etc.) are preserved. Thus it is possible to examine the trading of any particular group (public, members, or any class of members) with respect to stocks classified according to those characteristics; for example, public trading in low-priced stocks, member trading in volatile stocks, floor trader trading in active stocks, etc., as each stock displayed such characteristics on each day it traded-in other words, on each "stock-day." A complete explanation of the process of analyzing these data is set forth in app. VI-A. 183 See sec. 6.1, below. 184 Of course, the long-term investment position includes inventory which may or may not be held for 6 months or more. Nevertheless, these figures do represent the amount of stock that specialists have identified as stock being held for treatment as long-term investments. 96-74663-pt. 27 |