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6. Reference is made to the recommendation in part I of this chapter with respect to disclosure of the odd-lot differential in customers' confirmations of odd-lot transactions. Reference is made, also, to the recommendation in chapter VIII.B with respect to possible reduction of the round-lot unit.

PART F. FLOOR TRADERS

Of all classes of exchange members on the floor, the floor trader stands alone in having no fiduciary status, no duty to execute transactions, and no market responsibilities or obligations in relation to the operation of the market as a public institution. He is, in short, the only type of member granted access to the floor without being required or expected to participate in the handling of securities transactions. The floor trader's presence on the floor is simply a matter of his desire to trade for his own account. That any individual who purchases a seat thereby becomes entitled to do his personal trading on the floor of an exchange without having any special function or undertaking any obligation in relation to the operations of the market raises, in itself, a fundamental question of public policy as to the extent to which a public market may be permitted to maintain this vestigial "private club” aspect, even apart from very serious questions as to the net impact of floor trading on the orderly functioning of the market.

The privilege of access to the floor provides trading advantages of a substantial nature; the commission cost of trading on the floor is appreciably lower than for off-floor trading, trading activity may be observed minutes before it appears on the tape, and bids or offers may be entered or withdrawn in a matter of seconds. In addition, presence on the floor carries with it the benefit of what has been termed a "feel of the market”—a heightened sense of market tenor and trend. In part this "feel of the market” is attributable to the constant exchange of observations among floor members, either with respect to general market conditions or, more specifically, to such factors as the volume and type of orders or cancellations coming to the floor. More subtle factors also add significantly to the floor member's awareness; familiarity with the trading techniques of specialists or floor brokers, for instance, in many cases combined with knowledge that a large block of stock is being accumulated or distributed, is a factor that facilitates the trading activities of the floor trader.

Section 11 of the Exchange Act vests the Commission with broad powers to regulate or prevent principal transactions by exchange members on the floor of an exchange. It is clear that one of the major legislative concerns underlying this broad grant of power was that benefits derived by the public from member trading on exchange floors were not in balance with the advantages derived by the preferred groups. Viewed in this light the broad scope of the section is thoroughly consistent with one of the dominant themes running through the series of statutes administered by the Commission denial of special advantage in the public interest and for the protection of investors. The equality of access to full and accurate corporate information sought to be guaranteed by these statutes is complemented by the specific provisions of the Exchange Act which seek to provide open and honest markets in which investment decisions may be acted upon. In its administration of the statutes the Commission has shown that the guiding concepts are dynamic and not static. If anything, there has been an increasing emphasis on fairness and equality. A recent case, for example, has made it clear for the first time that a broker in possession of important nonpublic corporate information is under severe limitations as to the use of his knowledge in the marketplace. In a disciplinary proceeding within the last few months the NYSE found it contrary to acceptable business practice for a broker to trade on similar information. Although the content and quality of floor information and the "lead time" of a trader on an exchange floor may be different from the information and advantages noted in these cases, the principle remains the same. Only some strong, demonstrable, countervailing public benefit can justify the special advantages enjoyed by the floor trader. Absent such a balancing consideration, floor trading is an anomaly-a special advantage in a public market which can be enjoyed by purchasing access to the floor of an exchange.

2 Early drafts of sec. 11 would have turned exchanges into pure auction markets, banning all except brokers from access to the floor. See “Hearings on Stock Exchange Regulation Before the House Committee on Interstate and Foreign Commerce,” 73d Cong., 2d sess., pp. 116-117 (1934).

The anomaly becomes more disturbing in light of the fact that floor traders tend to have a destabilizing influence on prices. On at least 15 separate occasions since 1934, studies conducted by the Commission and the Division of Trading and Exchanges, confirmed by studies made by the Special Study, have shown that floor traders are generally buyers in rising markets and sellers in declining markets, with respect to both the market as a whole and to individual stocks. Their trading, as a result, is inimical to the orderly functioning of the market, tending to accentuate rather than to stabilize price movements.

Apart from its effect on price stability, floor trading has been defended on the grounds that added market liquidity and continuity are its beneficial byproducts. There is no doubt that floor trading, as does any kind of trading, adds liquidity to the market. The same may be said, however, of transactions effected in error, pool operations, wash sales, or other transactions generally acknowledged to be undesirable elements of a sound market. That is to say, added liquidity standing alone cannot justify trading that in other respects is deleterious. In addition, floor trading is heavily concentrated in the active stocks where added liquidity is needed least. Finally, to the extent that floor traders improve liquidity; they may, on occasion, fulfill a specialist's function but they remain totally free of the specialist's responsibilities.

Much the same considerations deprive the continuity defense of floor trading of much of its weight. Because floor traders concentrate their trading in the active stocks, the continuity they add is limited for the most part to the stocks that suffer least from lack of continuity. Such continuity, moreover, is obtained at the expense of permitting a type of floor activity that has an adverse impact on price stability. Again, in adding continuity they perform a specialist function without incurring specialist obligations. In at least one respect, the continuity defense of floor trading is definitely less persuasive than the liquidity defense; whereas floor trading may never be said to detract from liquidity, there are occasions on which floor trader participation in the market has a negative impact on price continuity. Due to the tendency of floor traders to trade with price trends, their participation in auction proceedings often adds to the imbalance of buyers and sellers and thereby encourages more rapid and sizable price changes.

8 In the matter of Cady, Roberts & Company, Securities Exchange Act Release No. 6668 (Nov. 8, 1961). This case held a broker-dealer in violation of secs. 17(a) of the Securities Act and 10 (b) of the Securities Exchange Act, for selling stock for his own and customer discretionary accounts, upon learning-one-half to three-quarters of an hour before the public--that the issuer had cut its dividends. (See ch. III.F. (pt. 1).)

Floor trader contributions to market liquidity and continuity, in short, are not of sufficient magnitude or importance to warrant retention of this vestigial “private club” aspect of the exchanges. If the exchanges feel problems of market liquidity or continuity exist, solutions should be sought which provide greater assurance of these qualities in those stocks and during those periods when they are most needed, rather than fortuitously or when and where least needed. Improving specialist capital requirements, for instance, or assigning floor traders responsibilities as "auxiliary specialists," would constitute more direct approaches to these problems, and the latter approach would enjoy the further merit of tempering special market advantages with definite market obligations.

Attempts to retain or expand the benefits of floor trading and at the same time curtail its undesirable characteristics have been nominally successful at best. In 1945 the Commission proposed the abolition of floor trading, but withheld action in light of repeated assurances that the exchanges would develop effective self-regulation of this activity. Despite the great variety and complexity of exchange rules experimented with to date, however, floor traders still retain their significant private trading advantages in a public market, continue to concentrate their activities in the more active stocks, and continue to accentuate price movements.

Self-regulation in this particular area has not only been generally ineffective, but in a most important respect it has been misdirected. The exchanges' regulation of other categories of members on the floor is generally to assure adherence to obligations designed to benefit the market. In the case of the floor trader, on the other hand, the exchanges have established elaborate rules and complicated enforcement mechanisms, the sole purpose of which is to restrict activities that are primarily of private benefit. The public interest cannot ignore this administrative burden required to police private investing practices on the floor.

The Special Study concludes and recommends:

1. Floor trading in its present form is a vestige of the former "private club” character of stock exchanges and should not be permitted to continue on the NYSE or Amex. The Special Study therefore recommends that, except as permitted under any program adopted pursuant to the following paragraph, (a) floor trading on the part of members and member firms of the NYSE and Amex whose income from floor trading in each of the years 1961 and 1962 amounted to less than 25 percent of their total gross income from all activities in the securities business (including floor trading) should be prohibited by a Commission rule under section 11(a) on and after January 2, 1964; and (b) floor trading on the part of members and member firms whose income from floor trading in either of the years 1961 or 1962 exceeded 25 percent of their total gross income from all activities in the securities business (including floor trading) should be prohibited by such rule on and after January 2, 1965. There should be excepted from these prohibitions, however, (i) transactions by specialists or odd-lot dealers in stocks in which they are registered, if reasonably necessary in terms of the functions served by such members; and (ii) transactions effected to offset transactions made in error.

2. It has been noted, in chapter VI.D (pt. 2), that the financial capacity of some specialists or of the specialist system generally is in need of strengthening, and it is possible that some present floor traders could perform a highly useful function as "auxiliary specialists." The NYSE and Amex should undertake studies, in conjunction with the Commission, as to the feasibility and desirability of a program under which present floor traders or other members of such exchanges might register with the exchanges as “auxiliary specialists,” with permission to trade on the floor in any security on condition that (a) the auxiliary specialist meets special capital requirements equivalent to those applicable to a specialist registered in (say) 10 average-priced stocks; (b) all transactions of such auxiliary specialist on the floor are either undertaken at the unsolicited request of a specialist and in accordance with rules similar to those governing specialists, or are effected for the purpose of reversing in whole or in part a transaction so undertaken. if such studies indicate the feasibility and desirability of such a program, it should be put into effect promptly with appropriate procedures for surveillance by the respective exchanges.

3. Since floor trading on regional exchanges in dually listed stocks does not appear to influence price movements or involve special advantages, a different approach or approaches to floor trading on regional exchanges may be warranted and should be the subject of separate consideration by the Commission. Among other things, consideration should be given to whether floor trading in solely listed stocks on regional exchanges is or is not comparable to floor trading on the NYSE and Amex.

PART G. MEMBERS OFF-FLOOR TRADING

Trading by NYSE members on the Exchange but from off the floor accounts for approximately 5 percent of total Exchange purchases and sales, but on occasion accounts for more than 50 percent of all purchases or sales in a given stock over a given day or week. Generally such trading is characterized by a tendency to favor stocks and stock days of high volume; and by a rather consistent pattern showing sig. nificantly more sales than purchases. The sources of the shares sold on the Exchange in excess of those purchased are generally considered to be stock splits or dividends or arbitrage purchases in other markets, but data have not been obtained to confirm these assumptions. Similarly, the extent to which member off-floor trading represents investment, speculation, arbitrage activity or other functions has never been ascertained. Until such data are available, no conclusions as to the significance of such trading may be reached.

The Special Study concludes and recommends:

1. The purpose, nature, and significance of trading by members from off the floor remain concealed in the aggregate data reported by such members to the NYSE each week. Because this trading on occasion accounts for a large percent of total trading in individual stocks, and may therefore have a substantial impact on the trading in such stocks, the propriety of expanding the present reporting requirements of members trading from off the floor should be considered by the NYSE and the Commission.

PART H. SHORT SELLING

Short selling not only is used by exchange members and members of the public for speculative purposes, but is used also by arbitragers, specialists, and odd-lot dealers to facilitate market operations, and is used generally for hedging and tax purposes. The practice was the subject of much difference of opinion during the congressional scrutiny which led to passage of the Securities Exchange Act of 1934, and at least after each major downward plunge of market prices, its utility and impact have been vigorously debated.

The Exchange Act made short selling subject to the full regulatory power

of the Commission. The current rules governing the practice incorporate limited changes from the original. Short selling is allowed only at a price above the last different one; also, short sales must be marked "short” on the order slips. Various exemptions have been made from the price requirements, the most important of which are for arbitrage transactions. Exempt short sales are required by the Exchange, with the concurrence of the Commission, to be marked "short-exempt." The Special Study's investigations suggest that there is some laxness in the observation of the Commission's short-exempt rules, and that the records by which compliance may be checked are not adequate.

The only data regularly compiled and published concerning short sales are daily aggregate figures for all stocks on the New York and American Stock Exchanges, and monthly figures on the short positions in certain stocks of the NYSE and in all securities of the Amex. Analysis of such data permits only broad conclusions about short selling practices. In recent years, such selling has varied from a low of about 3 percent to a high of over 8 percent of total NYSE share volume, dropping to the lower percentages as stock prices reach a peak and advancing to the higher as prices approach their bottom levels. This tendency for the ratio of short sales to increase as a market decline progresses, which is attributable principally to increased short selling by nonmembers, calls into question the classic argument that short selling (because of later covering purchases) has a stabilizing influence during market declines.

Ordinarily, nonmembers' round-lot short selling in the aggregate is small compared with their total round-lot sales, especially toward the end of a sustained rise, when the ratio tends to fall below 1 percent. During market declines the ratio has risen to around 2 to 5 percent, while in the critical break of May 1962, the ratio rose to more than 4 percent and to almost 7 percent during the further decline in June. The odd-lot short sales are quite small compared with round-lot short sales during advancing markets, but rise, relatively, as the market

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