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representing the firm which forwarded the order should initial the specialist's memorandum of each such transaction. In its routine surveillance the Exchange should systematically review transactions covered by such memoranda in light of subsequent transactions by the specialist.
(f) To keep within as narrow limits as possible the conflicts of interest inherent in a specialist's combination of functions, NYSE and Amex specialists and their firms should be prohibited from servicing the accounts of public customers, or receiving commissions on such accounts "introduced” by
them at other firms. 8. No information is now publicly available with respect to specialist dealer activity in individual stocks. The NYSE and Amex should report to the Commission on a weekly basis each specialist's purchases and sales as principal in each issue traded. Such reports should be made public so as to give interested investors an indication of the degree of activity, exclusive of specialist participation, in particular issues. On the other hand, in its public statements on specialist activities the NYSE has tended to exaggerate the degree of stabilizing that specialists accomplish or could be expected to accomplish. The Exchange's “tick test," whatever its other uses, is not by itself significant as an evaluation of "stabilizing” of the market by specialists and should not be so represented.
9. The NYSE and Amex should undertake studies, in conjunction with the Commission, as to methods or plans by which the capacity of specialists to acquire larger blocks of stock within the framework of the auction market could be otherwise strengthened. Among other possibilities, consideration should be given to (a) the establishment of an exchange-administered capital fund from which specialists could borrow under appropriate limits and safeguards; (b) the establishment of a capital fund, through contributions from the brokerage income of all specialists, that would be administered by specialists' representatives and/or the Exchange itself and would be available for taking positions beyond the financial capacity of an individual specialist; or (c) establishment of a system of limited self-insurance by specialists as a group. Reference is made to recommendation 4 above with respect to increasing the specialist capital requirement and the recommendation in part F of this chapter concerning the possibility of creating a category of “auxiliary specialists.”
10. The NYSE and Amex should be required to report to the Commission any indication that a registered specialist unit is in violation of its specialist capital rule or has received a margin call. These exchanges should adopt rules providing in substance that any member firm which clears for or finances specialists may not terminate clearing arrangements or call for additional margin without adequate prior notice to the Exchange. Where a specialist in financial difficulties cannot promptly secure additional capital sufficient to bring his account above the required margin maintenance, his stocks should be reassigned temporarily or permanently to units with capital adequate to handle them.
11. The NYSE has pioneered in the development of surveillance techniques regarding specialists' performance and has devoted considerable energy to this area. Nevertheless, its present techniques are not sufficiently refined to deal adequately with certain important aspects of the specialist's role and obligations. Among needed improvements on this Exchange as well as the Amex are the following, which should be developed promptly by the exchanges in conjunction with the Commission:
(a) For many routine surveillance purposes it would be invaluable, but it has not heretofore been practical, to have a means of preserving or reconstructing a specialist's book for a given period; modern automation techniques may well remove the practical difficulties and should be promptly explored.
(b) Surveillance of overparticipation as well as underparticipation should be strengthened; as a basic check, regular reporting to the respective exchange of income of specialists, segregated between brokerage income and dealer income, should be required.
(c) In general, surveillance should be directed toward assuring that each specialist is performing his obligation to maintain a fair and orderly market in each security, with appropriate procedures and sanctions for enforcement and with the ultimate purpose of allocating and reallocating securities where required to assure high standards of performance with respect to all securities.
(d) In addition to present tests to evaluate performance, tests for evaluating specialist purchases, sales, and positions in relation to price movements should be evolved, with the object of determining the market effects of specialist dealer activities.
PART E. ODD-Lot DEALERS
About 10 percent of the share volume on the New York Stock Exchange, and a much higher percentage of the transactions, is represented by odd lotstrades in fewer shares than the minimum round-lot unit (in most stocks, 100 shares). The two member firms of Carlisle & Jacquelin and DeCoppet & Doremus for many years have jointly dominated the handling of odd lots on the NYSE, doing about 99 percent of the business. An odd-lot customer deals with these firms only indirectly, through his commission firm. The oddlot order is executed with the odd-lot firm at a price determined by the price of the next round-lot sale in the security, plus the "oddlot differential” of a quarter or an eighth of a point (or, for the seller of the odd lot, minus such an amount). The execution of odd-lot orders, which is purely mechanical and' in fact is often done by a clerk, is carried out by about 100 floor brokers who work exclusively for one or the other of the two odd-lot firms. The seats held by these brokers, together with those held by the odd-lot firms partners, account for about 10 percent of the NYSE membership; in contrast, the two largest commission firms have about 1.5 percent of the membership.
The Exchange has allowed the odd-lot differential to be established by the odd-lot firms themselves rather than by Exchange rule, apparently on the theory that a price differential as distinguished from a fee or commission is a matter for negotiation between the odd-lot firms and other member firms. Price competition has not existed between the two major firms for decades, and limited price competition from other member firms was effectively discouraged by a uniform price policy adopted by the Exchange in 1938. Certain of the regional stock exchanges, which theoretically might be a competitive factor with respect to dually traded stocks, have acceded to pressure for uniformity exercised by the New York odd-lot firms and the dual members.
There has indeed been some competition between the two New York firms in the rendering of services such as providing current market information, liberally adjusting transactions to correct errors, and making interest-free loans by means of borrowing large amounts of stock. All of these services, however, are provided by the oddlot firms to other member firms, particularly the commission houses who provide their odd-lot business, and are only indirectly and partially for the benefit of public odd-lot customers who bear the cost.
The commission firms could hardly have been expected to champion the interests of public customers with respect to the amount of the differential. Indeed, where there has been occasion for them to be heard, their principal concern has been to avoid the embarrassment of having to choose between better prices for their customers and better services for themselves. Hence it does not seem realistic for the Exchange to go on the theory that the differential for odd lots is purely a matter for negotiation between trading firms, since this ignores the reality that the differential is established unilaterally and is borne solely by the odd-lot investor. Likewise, it does not seem realistic to rely on competition in rendering services to the commission firms, since this ignores both the deterrent effects upon actual and potential competition and the passing of the whole cost burden to the public odd-lot customers, who are only the partial beneficiaries of the services.
A duopoly dominating a large and important public business would seem a classic case for rate regulation, and the Exchange has clear statutory authority to regulate, yet it has failed to exercise its jurisdiction and thereby disavowed responsibility. Nor has the Commission ever formally exercised its authority under sections 11(b) and 19(b) of the Exchange Act with respect to the differential or other aspects of odd-lot dealer activities.
As to the other aspects of odd-lot operations, though the Exchange formerly had a standing committee with jurisdiction over odd lots and though it acknowledges that it has full power to regulate oddlot trading, it has chosen not to exercise that power in the last 25 years. The Commission's suggestion in 1950 that the Exchange consider adopting special rules and regulations did not produce any results.
If the handling of odd-lot transactions is essentially mechanical, the handling of offsetting round-lot transactions involves possibilities of special advantage that would seem to call for surveillance if not affirmative regulation. This has received congressional recognition in section 11(b), where it is provided that exchanges may permit (subject to the Commission's residual power of veto or amendment) an odd-lot dealer to buy and sell for his own account,
with this explicit limitation: "so far as may be reasonably necessary to carry on such odd-lot transactions
At a minimum, the transactions should be systematically reported, as floor traders' transactions are now reported, and the Exchange should itself supervise the handling of odd-lot brokers' "triggering" round-lot transactions.
The matter of automation is of a different character but is not less a matter of public concern. In 1956 the Exchange employed the firm of Ebasco Services, Inc., to make a study of possibilities for automation on the Exchange. The Special Study has reviewed the history of their proposals concerning the handling of odd lots and of the odd-lot firms attitudes and actions in regard to them. It is clear that the two firms regarded the possibility of automation as a grave threat to their duopoly, and it is difficult to escape the conclusion that they succeeded in warding off a consideration of the merits by emphasizing the potential impact on seat values for all members and otherwise beclouding the real issues of economy and efficiency. More particularly, they almost immediately succeeded in establishing the principle that the full complement of associate brokers, with their approximately 100 stock exchange seats, was sacrosanct; and once this principle was accepted, the potential for substantial savings vanished and automation was doomed. Automation, whether of factories, railroads or securities markets, always presents difficult problems and conflicting interests—often including the public interest-but it is unusual to have the problems and conflicts resolved with the factor of cost-savings eliminated at the outset.
That the odd-lot firms themselves would resist any plan for modernization which would reduce their profits, eliminate many associate brokers, and make it easier for competition to develop is not surprising. It is regrettable, however, that the Exchange was so ready to accept their contentions and that the commission firms did not feel called upon to voice the interests of public odd-lot customers, whose business both the Exchange and the firms actively solicit. Finally, it is to be noted that the Commission apparently was not advised of the Ebasco proposals at any point, and there was no governmental representation of the public interest in any stage of the deliberations.
This history has significance reaching beyond the specific subject of odd-lot automation. In an age in which electronic means of communication and data processing are being constantly improved and expanded, there are certain to be many valuable new techniques for the securities markets, if not in the next year or two then in the next decade or two—“certain,” that is, if the possibilities are not stifled in private discussions among those with vested interests to protect. Securities markets are not inherently more immune from featherbedding than any other business.
If the securities markets are to be truly public institutions, as they have been under the law for 30 years, the public interest in questions of automation must have a voice. The Commission should equip itself to keep abreast of electronic and computer developments in the securities industry. Otherwise, these may be neglected or suppressed for want of any consideration of the public interest.
The Special Study concludes and recommends:
1. Although existing problems in the handling of odd-lot business on the New York Stock Exchange and its regulation by the Exchange and the Commission can be pointed out with considerable specificity, it has not been feasible nor would it have been appropriate for the Special Study to undertake the detailed studies required to arrive at specific answers, as distinguished from pointing out the kinds of studies still needed in order to make appropriate and effective improvements. Especially because the problems revealed affect the small investor, it is important not only that they be recognized, but that the Exchange and the Commission move with dispatch toward their resolution. In the absence of prompt and effective action by the Exchange, the Commission itself should directly undertake the needed measures.
2. The New York Stock Exchange should recognize and meet its responsibility to regulate odd-lot differentials. As a first step to that end, it should immediately undertake, with such participation of the Commission as may be found appropriate, a cost study of the odd-lot business. In such study, costs should be appropriately allocated so that odd-lot customers will not be charged for services rendered to others, including the odd-lot firms' cost of stock borrowing and of information services that benefit commission firms or their round-lot customers. As in the case of commission rates on round-lot transactions (see ch. VI.I (pt. 2)) the Commission should undertake a more affirmative role of oversight in connection with the determination of relevant costs and the fixing of differentials.
3. The Exchange should promptly adopt (i) appropriate rules governing the handling of odd-lot transactions and offsetting round-lot transactions (including but not necessarily limited to the problem of "triggering” round-lot transactions by odd-lot dealers, and the relationships between odd-lot dealers and specialists), and (ii) systematic reporting requirements and surveillance procedures concerning such offsetting transactions.
4. The Exchange should be directed to advise the Commission in writing at an early date (and from time to time thereafter so long as the Commission considers the question open) as to the feasibility of automating the execution of odd-lot orders and as to the possible effects of automation on floor operations, costs, and odd-lot differentials. In connection with its current plans for automation of certain functions and facilities, the Exchange should promptly advise the Commission in writing whether all or any part of the information services now rendered by the odd-lot firms to the Exchange and its members can and should be eliminated, modified, or replaced in any manner. The Commission should make such further studies of its own or in conjunction with the Exchange, and take such further measures, as may be indicated in light of the Exchange's advices on each of the above matters.
5. Inasmuch as the Special Study's consideration of the odd-lot business was essentially limited to the NYSE, the Commission should, in conjunction with the American Stock Exchange and the regional exchanges, undertake studies of the methods and costs of handling odd lots on those exchanges.