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Specialist Scandal Raises Stakes for NYSE Reform

October 19, 2003|Tom Petruno | Times Staff Writer

For a long time after the Nasdaq Stock Market was created in 1971, many big investors claimed that the electronic trading system was rigged to benefit Wall Street brokerages at investors' expense.

But market regulators mostly just winked and nodded at that contention. It finally took a Justice Department investigation of alleged brokerage collusion in the mid-1990s to force Nasdaq to begin cleaning up its act.

Those memories now are echoing in the canyons of lower Manhattan.

Already facing a deep crisis of confidence over the massive pay package given its now deposed chairman, Richard Grasso, the New York Stock Exchange last week announced that it planned to fine and punish five of its seven "specialist" firms -- the broker units that are the heart of the 211-year-old exchange's trading system.

The NYSE said an internal investigation of market activity from 2000 through 2002 turned up a pattern of abuse involving the specialists stepping ahead of investors who wanted to buy or sell shares. Instead of acting as a facilitator, matching a buyer with a seller, the specialists in some cases tried to profit by getting between the investors, buying from one and selling to the other.

The practice was, in the NYSE's words, "to the disadvantage of the customers." Some investors either paid too much or received too little in their transactions, compared with if they had simply been able to trade with one another.

On Wall Street, they like to say that the client comes first. The torrent of financial scandals over the last few years showed that that often is a bad joke.

But it's one thing for a retail broker to overcharge a few hundred clients for mutual fund shares. It's quite another if investors worldwide begin to think that the premier U.S. capital market is a con game.

Coupled with the Grasso debacle and the likely resignation of most of the exchange's directors once interim Chairman John S. Reed launches his overhaul of the market's governance procedures, the specialist investigation dramatically raises the stakes for the NYSE as it seeks to chart its future.

For decades, the exchange has successfully fended off criticism that its specialist-based trading system was an anachronism in the computer age. Did we really need human beings to oversee stock transactions on a trading floor occupying some of Manhattan's (and the world's) most expensive real estate? Why not just let computers match buyers and sellers automatically, without a middleman taking a piece of the action?

The Nasdaq dealer scandal in the mid-1990s helped the NYSE make its case that the specialist system -- human oversight of trading on a well-lighted floor always in the eye of CNBC cameras -- was fairer for investors.

Now, the exchange's allegations about its specialists' conduct are the equivalent of loading the cannons for its enemies. And those enemies include not only Nasdaq but also the host of other all-electronic markets that have sprung up as a result of the market reforms forced on Nasdaq starting in 1997.

On the same day last week that the NYSE put its specialists on notice that they would face "substantial" fines for their abuses, a House Financial Services Committee panel was holding a hearing on the structure of U.S. capital markets.

One of the people called to testify was Jerry Putnam, chief executive of the Chicago-based Archipelago Exchange. Putnam founded Archipelago in 1997 as an "electronic communication network," or ECN, to take advantage of the government's directives opening Nasdaq stock trading to significant new competition.

Since then, Archipelago has grown to become a major Nasdaq competitor. Archipelago says it handles 28% of trading in over-the-counter stocks, and is the largest trader of the very popular QQQ, a fund that mimics the Nasdaq 100 index of that market's biggest stocks.

ECNs such as Archipelago automatically match stock buyers and sellers based on the prices they indicate they'll accept. There is no specialist or dealer to get in the way -- or to help, for that matter.

The rise of ECNs has taken a huge bite out of Nasdaq's share of trading in its own stocks, to the point where Nasdaq's share now is a minority rather than a majority.

Archipelago also has tried to take on the NYSE. But the success of ECNs in attracting trades in NYSE-listed shares has been limited. The exchange still controls more than 80% of trading in its own shares, even as mergers have reduced the number of NYSE specialist firms to seven from 40 a decade ago.

Putnam and other NYSE rivals assert that the exchange has made itself into a fortress, and that its trading franchise has been preserved not by virtue of good service but by regulations and market mechanisms that keep competitors outside the fortress walls, at investors' expense.

The NYSE, Putnam told Congress, "evidences all the lethargic and inefficient symptoms of anti-competitive and monopolistic pathology."

The exchange has consistently rejected those allegations.

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