The Specialist System
As we know by now, one of Grassos
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
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.
Individual traders indicted in 2005 for securities fraud
(status as of April 13, 2005 per New York Times)
Van der Moolen
||no date set
|Donald R. Foley
|Scott G. Hunt
||no date set
|Thomas J. Murphy
||no date set
|Frank A. Delaney
|Kevin M. Fee
|Spear, Leeds &
|Robert A. Johnson
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.
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.
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.
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 America Corp.
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.
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
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
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.
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.