The Specialist System

As we know by now, one of Grasso’s primary (but unnamed) performance requirements was the successful maintenance of the specialists firms in the NYSE. The specialists were the members of the NYSE and did most of the trading. They also made a lot of money through their activities on the Big Board.

The specialists system is unique and as old as the NYSE, dating back to 1792. The system involves actual people standing on the floor of the exchange (theoretically at a “post”) and recording buy and sell orders in their “books,” from which trades are matched. Each specialist controls a group of listed firms.

As electronic trading became very practical (e.g., it was used successfully on the NASDAQ), almost obvious, the NYSE/Grasso continued to argue that their system of specialist firms was the most efficient and must be used “to maintain an orderly market.”

But in 2003, 15 former NYSE floor traders were indicted by federal prosecutors and charged with cheating customers by mishandling trades to enrich their own firms. The SEC also filed securities fraud complaints against the 15 and against 5 other traders, saying they had made thousands of illicit trades from 1999 through 2003.” At the same time, the NYSE settled SEC accusations that it failed to regulate its trades properly.

They have unfamiliar names but they represent The Street. A list was presented in 2006 in the New York Times, showing the status of fifteen individual traders (who had been indicted in 2005) and their “home base.”(specialist firm). They were indicted on charges of securities fraud in a suit by the SEC and New York State.

Figure 3
Individual traders indicted in 2005 for securities fraud
(status as of April 13, 2005 per New York Times)

Van der Moolen


Patrick McGagh guilty plea
Joseph Bongiorno guilty plea
Michael Hayward trial June 14
Richard Volpe summer
Michael Stern trial June 14
Gerard Hayes summer/Fall
Robert Scavone summer
Fleet Specialist  
David Finnerty no date set
Donald R. Foley II November
Scott G. Hunt no date set
Thomas J. Murphy Jr. no date set
Bear Wagner  
Frank A. Delaney IV November/December
Kevin M. Fee October
Spear, Leeds & Kellogg  
Robert A. Johnson Jr. May '07
Freddy DeBoer never apprehended

The situation of the specialists was summarized in a Wall Street Journal article in 2006 by John Bogle:

“Lauren Goldberg said the trader, who served as the specialist for one of the NYSE's most active stocks, General Electric Co., improperly positioned himself between public buy and sell orders more than 26,000 times between 1999 and 2003. As a result, he made more than $4.5 million in illegal profits for the firm, she said.

“Frederick Hafetz, Mr. Finnerty's lawyer, countered that the trades, which accounted for less than 1% of the trades Mr. Finnerty executed at the time, were simply the result of mistakes and miscommunication during a frenzied period of trading at the Big Board.

“In total, prosecutors have brought criminal charges against 15 former specialists for allegedly making improper trades at the exchange. Two pleaded guilty in May, and two were convicted of securities fraud in July.

“Mr. Finnerty, who is accused of making improper trades in GE and two biotechnology stocks, is charged with three counts of securities fraud and faces a maximum of 20 years in prison if convicted. Fleet Specialist, now known as Bank of America Specialist Inc., is a unit of Bank of America Corp.

“Meanwhile, the two former specialists who had pleaded guilty in May were sentenced Friday. The two traders, formerly at Van der Moolen Specialists USA LLC, were each sentenced to more than two years in prison after pleading guilty to making improper trades at the NYSE.

“U.S. District Judge Sidney Stein in Manhattan sentenced Joseph Bongiorno and Patrick McGagh to 27 months in prison, to be followed by two years supervised release. They also were each ordered to pay a $250,000 fine.”

Improper trading took various forms. First, “certain of the firms’ specialists ‘interpositioned’ the firms’ dealer accounts between customer orders by trading into both of them in succession – for example, buying into a customer market sell order first, and then selling, at a higher price, into the opposite market buy order, thus allowing the firm dealer account to profit from the spread.”

“The regulators also found that the specialists traded for their dealer accounts ahead of executable agency orders on the same side of the market, orders that were executed later at prices inferior to the prices of dealer account trades.”

“At other times, the specialists traded ahead of executable limit orders, which then went unexecuted and ultimately were cancelled by the customers entering the orders.”

John Bogle (in his 2003 Remarks) presented several examples of the problems created by the use of specialists:

“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 money.

“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. "

Bogle also suggested a hypothetical situation involving “SpecialistMan.” –

“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 profits.

“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.”

For example, “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.”

How about that? I wish we had a picture of Specialist Man, with a huge S on his chest.

Anderson, Jenny, “15 Specialists from Big Board Are Indicted,” New York Times, April 13, 2005, C1.

New York Times 2006 (NYState and SEC), source: U.S. Attorney’s office

Bogle, John A., 2003. “Remarks of John A. Bogle,” The Wall Street Journal, September 19. (LINK #6)

U.S. Securities and Exchange Commission, 2004. Press Release: “Settlement Reached with Five Specialists Firms for Violating Federal Securities Laws and NYSE Regulations,” 2004-42.

U.S. SEC 2004. Press Release 2004-42. “Settlement Reached with Five Specialists……”