Well-deserved attention has been focused on the $140 million
compensation package received by Richard Grasso, the recently
departed chairman of the New York Stock Exchange. Undoubtedly there
will now be significant changes at the NYSE Board. But the real
question is why that Board, with representatives from the most
sophisticated firms on Wall Street, agreed to pay its chairman such
a rich compensation package. There is only one conclusion: He was
worth the money.
While the NYSE bills itself as "a private company with a public
purpose," there is no doubt that its chairman's most important role
is to protect the interests of its members. And no interest is more
important than the protection of the trading profits derived by the
NYSE's floor-based specialists. Thanks in large part to Mr. Grasso's
efforts, the NYSE has, until recently, enjoyed a remarkable level of
prestige, providing the cover necessary to protect its inherently
unfair and inefficient trading system.
Every security traded on the NYSE is assigned exclusively to a
specialist firm. The specialist ultimately sees every order in its
assigned stocks submitted to the exchange either electronically or
through brokers on the floor. But while the NYSE grants specialists
a privileged position in order to maintain a "fair and orderly
market" (which, curiously, is nowhere defined), the specialist is
also permitted to simultaneously trade for his own account -- an
obvious conflict of interest.
NYSE rules attempt to limit the specialist's ability to
improperly use inside information by limiting specialists to trading
only when there is a temporary disparity between supply and demand,
buying when there are no other buyers and selling when there are no
other sellers. Yet if specialists really traded only when there is
an absence of buyers or sellers, one would think they would lose
The fact is that specialists are profitable, in Samuel Johnson's
words, "beyond the dreams of avarice." A forthcoming study by
Precision Economics will reveal that publicly traded firms with
specialist units last year enjoyed pre-tax profit margins ranging
from 35% to 60%. Labranche, the largest NYSE specialist, generated
more than a quarter of a billion dollars in revenues, almost
entirely from trading for its own account on the floor. Pretty
profitable for trading only when nobody else wants to!
Since trading is a zero-sum game, these profits come at the
direct expense of investors such as large institutions, which
desperately want competitive alternatives to the NYSE but are
reluctant to publicly complain about the fundamental unfairness of
the NYSE model. After all, institutions have to do business with the
NYSE because there are no real competitive alternatives.
The NYSE has perpetuated myths that mislead regulators and the
investing public into believing that specialists serve the public.
For instance, the NYSE asserts that investors need specialists
because without them, "who is going to be there to buy or sell when
nobody else wants to?" The NYSE claims that the specialist reduces
market volatility by acting as the buyer or seller of last resort.
Think about that: Envision SpecialistMan, emerging amongst the
bedlam of a fast falling stock with a giant "S" on his chest.
Quickly calming the crowd, he exclaims "I will buy from every one of
you because it is my duty, even though I will lose money." They sell
their shares to SpecialistMan, praising him for his willingness to
selflessly provide liquidity, regardless of the impact on his
While this notion is ridiculous on its face, it is still put
forward to defend the NYSE specialist when nearly every other major
instrument is traded completely electronically without anyone being
given an informational advantage. The truth is that when a stock
like Enron starts falling, just like everyone else, SpecialistMan
gets out of the way.
We ought to ask ourselves why we even want a specialist to manage
the decline of a stock. In an efficient market, that is the last
thing we should want. The market should be permitted to clear --
move to its equilibrium point -- as quickly as possible, without
somebody trying to manage the process. A slowly declining stock only
hurts buyers at the expense of sellers, and vice versa.
We need not worry about the specialist abusing his privileged
position, we are assured, because the NYSE's cardinal principle is
that the investor's interest is always served first. But it's easy
to get around this tenet. Even though there is no imbalance between
supply and demand, the specialist simply trumps the price of
investor orders. If a specialist is holding investor orders to buy
IBM for $10.00, he cannot buy at $10 until all investor orders at
$10.00 are executed. But he can buy at $10.01. With his
informational advantage over everybody else concerning the likely
direction of a stock's price, the specialist will outbid investors
only at the most advantageous moments.
Ironically, the specialist is rewarded for this exclusive
opportunity. The NYSE calls this "price improvement" because the
investor trading with the specialist receives a better price. The
NYSE actually brags about the frequency of price improvement, which
really represents how often the specialist uses his informational
advantage (what most of us would otherwise call insider information)
to make a trading profit and disadvantage investors.
These points should not be a revelation. Why would NYSE members
pay approximately $2 million for the privilege of standing on an
old, crowded floor all day unless they gained some sort of
advantage? Membership has its privileges. But does the public
benefit from a structure that grants privileges to a select few even
though, thanks to technology, we now have more efficient ways to
SEC rules ban floor brokers from trading for their own accounts.
Specialists, however, are exempted from this prohibition because
they are assumed to be performing a public service, an assumption
belied by the facts. So let's be clear. While the NYSE Board
structure needs to be fixed, and fixed promptly, we investors ought
to focus most of our attention on the profit center of the NYSE, its