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risk of loss, even though there may be an inconsistency between this practice and the regulatory limitations placed upon his conduct and his responsibilities as a marketmaker. These problems are described below and some of them are more fully discussed in the succeeding sections.

First, to maximize profitable trading the specialist may seek to trade as often as possible in active stocks. The more often he can fit within the spread the more often he can profit.

(Second, the specialist may tend to engage in "daylight trading, i.e. activity calculated to avoid carrying an overnight position.

185

Third, problems arise from some of the techniques used by the specialist to liquidate inventories. He can adjust the spread, i.e., the price of his bids and offers (within the framework of the public market) while adjusting the size of his bid or offer. He can make the size of his offer larger in relation to his bid so that in the normal course of the day he sells more than he buys:

Q. Would you become a better seller than buyer [to reduce a long position]? Would your offer be bigger than you bid?

A. On every rally, instead of letting a stock say, rally two dollars, you might let it rally half a dollar and just keep offering stock.

This is merely part of the normal trading activity by which the specialist realizes his trading profits. However, some specialists have testified that these methods are passive: if there is insufficient demand at the market, changing the offering price or the size of the offer will be ineffective to liquidate inventory. If the specialist is unable to sell at his offer he can sell to the public bids, which will often be limit orders to buy on his book.188 When he does this, he is not realizing the normal jobber's profit. Such "reaching" across the market by the specialist is a more active form of liquidation than when he sells at his offer, and may result in an immediately lower price than the preceding transaction 187

(Fourth, the specialist can attempt to maximize the "jobber's turn" by quoting his stock with a wide spread. For example, if the spread between his bid and offer were 34 rather than 11⁄2 of a point, the specialist has a potential of an extra 14-point profit. The problem of spreads becomes even more acute in inactive stocks where the specialist will widen the spread to protect against a possible inventory loss by increasing the potential dealer profit as much as possible. The most extreme manifestation of this is found in the practice of nominal quotes which some specialists use in very inactive stocks. The specialist will quote on side of the market so far from a realistic price that no broker would deal at the quotes established. When an order does come to the floor, the price can be negotiated or, rather than deal him

185 It will be recalled that the Saperstein Interpretation generally requires each trade to be affirmatively justified by market necessity. The vice here is that there may be some trading calculated to reduce positions not so justified. On the other hand, there may, at some times, be a failure to trade to avoid accumulating an inventory. See sec. 6.g,

below.

198 These are the transactions which are generally prohibited by the Saperstein Interpretation except for the liquidation of positions. See sec. 6.b, above.

187 The problem of liquidating a position is present in many areas of trading. It is for this reason that floor traders generally trade in active stocks (see pt. F of this chapter), and regional stock exchange specialists are reluctant to assume positions in their sole listings unless these stocks have a large public market. (See ch. VIII.E.)

self, the specialist may seek a counter party among member firms who have previously manifested an interest in the issue.188

Thus, the profit pattern will not only tend to cause wide quotes in inactive stocks, but the specialist may attempt to avoid participating or taking positions in such stocks. The 3-week study showed 56 percent of the stock days in which specialists participated were in the top half of all stock days ranked by activity, the other 44 percent of the stock days in which they participated falling in the bottom half (chart VI-3). Although the tendency is slight, it is made more significant by the fact that it is precisely in the inactive stocks that specialist participation is most needed, and it is confirmed by several specialists who testified that they are reluctant to take positions in inactive stocks.

The reason is fairly obvious; a position in an inactive stock with a thin book would tend to "lock in" the specialist. In such issues, he has no assured flow of orders through which he can quickly realize the "jobber's turn." Although he may buy at his own bid, the lack of a counter party within a reasonable time compels him to hold the stock in inventory at the risk of market movements. By the time a counter party arrives in the market, extrinsic events may have changed the price to a point where the specialist can no longer realize a profit by selling at his own offer. As was pointed out above, even a wide spread is no longer a source of profit or even protection against loss.

There is not only general lack of activity in such stocks, but their books are likely to be thin (table VI-21) so that he lacks the "escape valve" of trading with the book to reduce his position.189 The floor department frequently exhorts specialists to close spreads and make better price continuity in the less active issues, but very often it is deemed an acceptable excuse that the issue is an inactive one with few orders on the book.

Thus, it seems that in inactive issues where specialist participation may be most needed, the risks are greatest while the chances of trading profit are lower, so that the specialist's incentives for making a close, continuous market are reduced.190 Conversely, the more active the issue, the greater the specialist's economic incentive to carry the concepts of liquidity and continuity as far as possible: the depth of the book and volume of general activity provide means for liquidation, while the turnover assures continuous profit from the "jobber's turn." In view of the economic motivations underlying the trading tendencies, it is somewhat surprising that Exchange officials testifying as to the Exchange's position vigorously denied that surveillance of specialists should include judgments as to the profitability of particular transactions; in fact, profit and loss data are generally ignored with

188 The clearest example of this phenomenon is to be found at "Post 30," where a large group of inactive stocks are handled by one specialist unit. These specialists take only nominal positions, usually for odd-lot purposes. Their office maintains 28 wire connections with member firms interested in these issues. When an order comes to the floor the specialist makes use of this extensive wire network to find interest. When the specialist does consummate the transaction, the parties will usually give him part of the order to "write out," so that he is compensated by floor brokerage.

150 One specialist with mainly inactive stocks testified:

"Q. How do you go about adjusting your own position?

"A. It is very hard in our case. You can't turn around and say; 'I will sell the stock to a bid,' because our books are very thin. But, to say that we have any means that we can reduce our positions, in our stocks, we cannot do it."

190 This must be qualified: there are many differences between specialist units, and some make better markets in inactive stocks than others.

respect to particular transactions or the overall situation of specialist units. However, on an ad hoc basis, the Exchange occasionally does take profitability into account when judging performance, usually in situations in which the economics involved are exculpatory, though in a few cases specialists have been criticized because their economic position was such as to have permitted better performance.1

191

A few examples may illustrate these points. A market study in ABC Vending was performed in May 1960 with respect to the price action of that stock near the close on April 29. The floor department concluded that because the specialist had a short position, his making a certain purchase to cover that position was justifiable despite the fact that the purchase caused price discontinuity.192 In response to criticism about their marketmaking activities, the specialists in South Puerto Rico Sugar stated that they had experienced a $50,000 loss in this stock (and a $70,000 loss in another issue) and that they were not willing to "sink any more money into a position in a stock that they knew would go down." The explanation was accepted. In a study of the sharp decline in American Optical on August 1, 1961, the floor department noted that since the specialist was short immediately before the decline, there were "some doubts concerning [the specialist's] *** failure to make a stand at some price instead of permitting it to sell down substantially in the last few minutes on low volume.193 From these and other examples,194 it would seem that the obligations of the statute and the Exchange rules are interpreted by specialists and in some instances by the floor department in a way that takes into account the specialist's immediate economic situation. However, as pointed out above, the Exchange utilizes such data in a vacuum because it generally ignores the overall profitability of the business.

d. Problems of participation

(1) Introduction

Even though the regulatory pattern contemplates that the specialist's basic function as dealer is to provide market continuity and liquidity, this does not answer the question of how much liquidity and continuity is called for either as a minimum or maximum; ì.e., the desirable level of specialist dealer participation in relation to the volume of trading in a particular security. This is among the most complex and subtle of the problems connected with the specialist role. It includes questions of both underparticipation and overparticipation-in other words, it relates on the one hand to the degree of obligation to participate and, on the other, to limitations on the freedom to partici

191 On only one occasion was a specialist warned that a specific stock (probably one of the most remunerative on the Exchange for specialists) was profitable enough so that he should be prepared to take a loss, in a range of $25,000 to $50,000, in maintaining a fair and orderly market. An Exchange official testified that, despite the general language in this admonition, this did not represent any general policy and, in fact, was limited to the specific facts concerning this particular stock.

192 Here the economic justification was sent to the complainant, a member firm, and apparently this is the only instance that such a justification of specialist activities was sent outside the Exchange or even to a member firm.

103 The public complainant was merely given aggregate figures with respect to the specialist's purchases and was told that because of "the records of the dealings of the specialist * and the selling pressure overhanging the market, we see no reasons to criticize the efforts of the specialist *

194 In one memorandum it was stated that the specialist "frankly cannot afford to go short any more ✦✦✦. [H]e has lost over $70,000," and in another the wide spreads in a stock were justified on the ground that the specialist was short and there was a persistent buyer.

pate. Also included is the question of "daylight trading," which may involve elements of both underparticipation and overparticipation.

The problem of "how much participation" is not wholly resolved in the following discussion, nor can it be: While it is possible to formulate more exact tests than those now used to measure the impact of specialist trading on the market, there is no single formula to determine in advance the appropriate level of participation generally or for particular stocks. In this and succeeding sections, therefore, the attempt is only to highlight various facets of the problem and to suggest, in the section on continuity with depth, appropriate principles governing the level of participation.

In light of the impossibility of devising a single hard-and-fast formula, it becomes necessary to administer the applicable standards in a discriminating and sophisticated manner, taking into account the varying needs and facts of the particular situation. At present the surveillance of the dealer function has been generally marked by indiscriminate encouragement of a high level of participation, failure to take action with respect to inadequate participation, and an apparent desire to project the image of the specialist as a market "stabilizer."

(2) Duty to participate

Section 11 of the Exchange Act has no provision requiring specialists to participate in the market as principal. Exchange rule 104, the basic provision governing specialist trading, prohibits specialists from engaging in transactions other than those reasonably necessary to maintain a fair and orderly market; in the supplementary material following rule 104 an affirmative obligation to participate is stated. This material states that the specialist's function "in addition" to the execution of agency orders is "the maintenance, insofar as reasonably practicable, of a fair and orderly market ***" A further elaboration merely states that in the discharge of this function "it is commonly desirable that [a] specialist engage to a reasonable degree under existing circumstances in dealings for his own account***" 195 In fact, specialists participated in one degree or another in 83 percent of the stock days during the 3 weeks studied; i.e., they participated to some extent in most stocks. The level of their participation is discussed below.

Although the supplementary material following rule 104 appears to require that specialists deal for their own account, there is no specific requirement that they quote a reasonable market (with respect to the spread between bid and offer). However, the Exchange often criticizes specialists for wide quotes and Exchange officials and various specialists agree that specialists are obligated to quote reasonable markets.196 In this connection, specialists are occasionally criticized for withdrawing a bid or offer and thus refusing to trade. In one such case, a specialist threatened to withdraw his offer after a dispute with a floor broker and was later informed that "under no circumstances should he ever threaten to withdraw a bid or offer." 197

195 NYSE Guide, par. No. 2104.10. It should be noted that this interpretative material seemingly has the force of a rule in that some years ago specialist registrations were revoked for failure to deal. See sec. 3.b, above. At the same time of the Pecora hearings the Exchange had no policy requiring specialists to deal. S. Rept. 1455, 73d Cong., 2d sess., p. 26 (1934).

198 The Exchange does tolerate the practice of nominal quotations in inactive stocks, as noted above. 197 On "firmness" in over-the-counter markets, see ch. VII.C.

(3) Level of participation

Routine surveillance of specialists has tended to emphasize greater participation. As noted above, one of the tests of specialists' performance measures nothing but participation. This test, commonly referred to as "TTV" (twice total volume), measures specialist trading against volume in each stock by doubling the volume and dividing it into the sum of the specialist's purchases and sales. 198 Doubling the resulting figure provides the percentage of the specialist's total participation in volume; i.e., the percentage of volume in which the specialist participated as either buyer or seller. Such a measure might be called the specialist participation rate or "SPR." 199 Whatever the formulation used, the growth in specialist participation since 1936-under the Exchange Act and the Saperstein interpretationis striking. Specialists from 1937 to 1953 had an SPR ranging from 15.5 percent to 21.2 percent. Starting in 1954, the SPR increased sharply until it exceeded 29 percent in 1959, 1960, and 1961 (table VI-27).

As was pointed out at section 6.b above, the Saperstein interpretation prohibits unnecessary specialist trading in view of the specialist's unique trading advantages and the conflict of interest inherent in the combined broker-dealer function. The degree of necessary participation in turn varies with different stocks, depending upon such things as activity, the thickness of book, and the price trend. Recognition of this required variation in participation may be found in a statement by the president of the exchange:

In so-called bread-and-butter stocks, like General Motors, Standard Oil of New Jersey, the big stocks, where the public activity is such that there is enough buying and selling so that the specialist does not have to participate very much the specialist maybe deals in 5 percent of the transactions. On the other end of the scale are the least well known stocks, where the public is not so active in the market, where the specialists may have to deal in 30 or 40 percent of the dealings.200

When the SPR was computed generally for all specialists and compared with volume, there was some tendency toward higher participation in the less active stocks (app. VI-A, table 5 and chart 5).201 Despite this tendency, however, some specialists have high participation rates in active stocks; for example, in 17 percent of the instances in which volume was over 10,000 shares a day during the 3 weeks, specialists had an SPR of more than 45 percent (app. VI-A, table 5).

Actually, participation seems to be as much a function of individual attitude and capital as it is of the qualities of particular types of issues.

198 For example, a stock for the period under consideration had a volume of 100,000 shares. The specialist bought 16,000 shares and sold 14,000 shares. His TTV is 15 percent, computed as follows:

Specialist: Purchases (16,000) + sales (14,000)=30,000
Twice total volume (100,000+100,000)=200,000

The maximum specialist TTV is 50 percent, because he can participate as dealer on only one side of each transaction.

199 Another measure of specialist dealer participation is to divide the number of transactions in which the specialist participated in a stock by the total number of transactions in that stock. During the 3-week study, specialists participated in a slightly lower percentage of transactions than of volume, with a transaction participation rate of 24.3 percent versus a 28.6-percent volume participation rate.

200 "Hearings on H.J. Res. 438," at p. 114.

201 This is not inconsistent with sec. 6.c, above, referring to whether there was any participation at all by specialists and noting their tendency to avoid inactive stocks; the discussion here concerns the participation rate in stocks in which specialists did participate. Because volume in these stocks are low, when the specialist does participate his rate of participation tends to be high.

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