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CHAPTER VI

EXCHANGE MARKETS

[Part A (Introduction) discusses the legislative background of the Commission's authority to regulate exchange markets. The chapter focuses primarily on the NYSE and includes a discussion of the diversity of securities traded on the Exchange and of its member firms.

[Part B (Operations of Exchange Markets) discusses the mechanics of market operations and the characteristics of members executing transactions on the floor.

(Part C (Members Transactions) is a general discussion of exchange members' trading for their own accounts and serves as an introduction to the succeeding parts dealing with specialists, odd-lot dealers, floor traders, and members' off-floor trading.)

PART D. SPECIALISTS

The specialist stands at the hub of the market mechanism of the NYSE and other major American exchanges. Since the inception of the specialist system about 100 years ago, the role of the specialist has increased greatly in importance. Starting essentially as a broker who had the function of storing limited price orders incapable of immediate execution, the specialist has also become a dealer who participates in a substantial percentage of exchange transactions for the purpose of maintaining a "fair and orderly market” in the securities in which he is registered.

The Special Study's examination of the NYSE specialist system has disclosed no widespread abuses or patterns of illegality. Nevertheless, serious problems have been found concerning the system itself and its surveillance and regulation by the Exchange. Certain fundamentals disclosed by the Special Study are at the core of these problems. The first is that in the last 25 years the specialist's dealer function has become as important as, if not more important than, the brokerage function-on both a quantitative and qualitative basis. The second is that the conflicts of interest inherent in any simultaneous combination of dealer and broker functions have been intensified, on the one hand, by this expansion of the dealer function and, on the other hand, by extentions of the brokerage function beyond that of handling market and limit orders for other brokers. The third is that there are wide variations in financial and other capacities, and in performance, among the 110 different NYSE specialist units, resulting in considerable divergency in the nature and quality of markets for individual securities even apart from inherent differences in their market characteristics, and indicating that the regulatory framework permits too wide á tolerance from acceptable norms.

A. THE SPECIALIST AS DEALER

The specialist's participation in the market as dealer has increased steadily through the years. Today, specialists are purchasers or sellers in approximately 30 percent of all exchange transactions. In 1960, approximately one-third of all specialists derived a greater part of their income from dealer profits than from brokerage commissions.

The basic dealer function, the maintenance of reasonable price continuity, is a useful one in several ways. A market which moves in small fractions probably tends to discourage undue speculative activity. Transactions in a particular stock on a particular day are likely to involve only a small number of shareholders, some of whom may have peculiarly urgent needs to liquidate their positions, and a responsible dealer system can prevent sudden changes in prices caused not by changes in intrinsic worth or general market conditions but by vagaries of supply and demand at a particular moment. The specialist serves as nexus between buying and selling orders, which arrive haphazardly rather than simultaneously in a continuous auction market.

A considerable portion of specialists' dealer profits are derived from the "jobber's turn”—the profit realized by purchasing from members of the public at the quoted bid and selling to them at the quoted offer. Since the potentialities for profit are greatest in the more active stocks, specialists' dealer activities tend to be concen rated in these stocks. Furthermore, the risks of acquiring an inventory are smallest in active stocks, which have the greatest volume of market orders and usually the thickest “books”—the unexecuted orders on both sides of the market entrusted to the specialist for execution—with which the specialist can trade in order to dispose of a long or short position. Responsible professional participation is needed most, however, in the least active stocks, where risks are greater and profit potentials are more limited. The Exchange has a policy of assigning certain types of stocks to well capitalized specialist units with a high rate of dealer participation, but there is no attempt to give each unit a "balanced portfolio” so that a more or less assured dealer profit and brokerage income in stable issues can be available for volatile stocks and inactive issues. Thus there is no systematic method of allocating total capital resources of the specialist system to less profitable as well as more profitable issues.

Closely allied with the problems of assuring adequate participation in inactive issues is the great difference between the concepts under which so-called “dealer specialists” (well-capitalized units with a high rate of dealer participation) and "broker specialists" (units which emphasize their brokerage function) seem to operate. The increasing importance of the specialist's dealer function for the entire market is making this gulf so wide as to threaten the image of the Exchange as a marketplace whose specialist system assures strength in all markets. The extent of dealer participation on the part of different specialists depends in considerable degree on the adequacy of their capital, and thus an adequate capital provision is a basic prerequisite for a strong specialist system. This is true not only in respect of extraordinary demands on the system in the handling of large blocks, as discussed below, but also in respect of more routine market situations, as illustrated by those specialist units which endeavor to end each day with as small a long or short position as possible (“daylight trading”), in order to avoid risk and capital commitment. The capital requirements of specialists, designed to assure that specialists have sufficient funds to maintain fair and orderly markets, have not been increased by the NYSE for many years although they were established at a time when market conditions were vastly different from those existing at present. In terms of units of stock (but not necessarily dollars) they are lower than Amex requirements as recently increased.

Just as underparticipation by some specialists in some situations raises one set of questions, so also are there important questions of overparticipation by specialists. The latter questions had earlier recognition and emphasis in regulatory terms; under the Exchange Act, a specialist's dealer transactions are to be restricted “so far as practicable to those reasonably necessary to maintain a fair and orderly mrket," and this standard was early defined (in the Commission's so-called Saperstein Interpretation of 1937) as relating to price continuity and minimizing the effects of temporary disparities between supply and demand. Despite the restrictive tenor of the statute and its official interpretation, the NYSE, particularly in recent years, has emphasized high dealer participation as a general standard for specialists.

The restrictive purpose of the Saperstein Interpretation should receive new emphasis in the form of a Commission rule, while at the same time the affirmative obligation of specialists to make fair and orderly markets should also be set forth in such a Commission rule. Exchange rules should then give further content to both aspects, by expressing as specifically as practicable the requirements and standards deemed applicable to typical problems of overparticipation and underparticipation as they have arisen in respect of various market situations and among different specialist units. In particular, there should be greater emphasis on what might be termed “continuity with depth, i.e., with reasonable volume at each price level, rather than mere price continuity without regard to volume. The total aim of Commission and Exchange rules should be to focus more closely on experienced problems of each type, overparticipation and underparticipation, rather than blanketing all problems of specialist participation under a general emphasis either on minimum participation or high participation.

As specialists' dealer participation has increased, there has been a growing tendency by the Exchange to express the utility of the specialist dealer function in terms of "stabilizing”. prices (as distinguished from providing transaction-to-transaction continuity). To measure specialists' stabilization performance, the Exchange uses the "tick test," under which, in general, a purchase below or a sale above the price of the last different transaction in the stock is deemed to be stabilizing. The results of the Special Study show that, under the tick test or other tests of stabilization, the stabilizing effect of specialist trading varies considerably among specialist units and in differing circumstances, so that aggregated data obscure wide disparities.

During the May 1962 market break, specialists as a group did not have a significant stabilizing effect on the market, though as a group they had been reducing their inventories since the end of 1961, and there were wide differences in performance among specialists. The data collected concerning the market break demonstrate that the tick test is an inadequate measure of stabilization, since it fails to take account of specialists' trading in relation to the overall trend of the market. The Exchange should not only develop more effective methods of testing specialists' performance, but should apply its regulatory authority to bring deficient specialists up to an acceptable level. It should be emphasized, however, that ordinarily the capacity of specialists to provide price stability is a distinctly limited one. No system of dealer trading can be expected to stabilize-in the sense of preventing price changes

in a market subjected to heavy public buying or selling.

Although the Saperstein Interpretation emphasized that each dealer transaction must meet a test of affirmative market necessity, some specialists have claimed that they have the right to liquidate their inventory if it becomes financially necessary to do so, regardless of the market effect of such liquidation. Connected with this is the view that a clearing firm financing a specialist has the right to instruct the specialist to liquidate his position without prior notice to the Exchange. During the May 1962 market break, a few specialists were in financial difficulties. It is not clear whether the Exchange was aware of the financial condition of these specialist units, but in any event no corrective action was taken. It is imperative that the Exchange keep itself informed of specialists' financial condition on a current basis, and that stocks registered with specialists who find themselves financially unable to perform their dealer function adequately be promptly reallocated, in order to assure the public the continuous benefits of specialists' performance.

The Saperstein Interpretation is ambiguous as to whether the policy against a specialist's “cleaning up the book” applies to liquidating a position. This ambiguity should be resolved by making the policy applicable to liquidations, and relevant standards and procedures in respect of acquiring or liquidating a position against the book should be more specifically defined.

Increasing institutional participation in the market has changed and may still be changing the kind and degree of demands on the specialist system, because the tendency of institutional investors to deal in large blocks tends to increase temporary, disparities between supply and demand. Specialists vary considerably in their willingness and ability to buy or sell susbtantial blocks at prices close to the last sale price. To preserve the Exchange's place as a centralized market, mechanisms for orderly trading of blocks in all listed issues within the auction market should be reexamined and strengthened where possible and, to meet this specific need as well as the general need mentioned above, specialists' capital requirements must be reevaluated.

The dealer activities of some specialists are influenced by tax considerations rather than the needs of the market, especially where specialists segregate holdings of securities in which they are registered into long-term investment accounts. These accounts raise several types of questions. First, their existence is generally inconsistent with the Saperstein Interpretation, because neither the ac

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