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for the execution of a trade, such practice removes the non-
non-member customer. 63 To remedy this problem, the staff suggested that transactions between NYSE members and third market-makers be made subject to the protective features of the exchange market, rather than prohibited:
The desired situation appears to be to give commission firms maximum access to all bids and offers to promote best executions without fractionalizing the market in a way that frustrates that purpose. In our view this can best be accomplished if the New York Stock Exchange were to return to a principle it formerly recognized and which other exchanges observe today: a broker executing an order for a customer is not entitled to a second commission from a party sought out by the broker to fill the other side of the order. In other words, a broker executing an order for a customer by dealing with a non-member market-maker would not be required to charge that dealer a commission. The order should still be brought to the floor (as member crosses now are) so that the beneficial aspects therein involved would be preserved, such as priority of bids and offers, publicity, regulation, and depth; we believe that the quality of executions would be benefited and the so-called "third market” would remain as a com
petitive force in the overall market. 64 The Subcommittee believes that this is the proper approach toward implementing the constructive aspects of Rule 394. In fact, with the movement toward competitive rates and a consolidated tape for reporting transactions, this approach is fully consistent with the goals of a central market system outlined by the SEC in its market structure report.
A principal purpose of a central market system is to enable investors to obtain the best execution of their orders by having them exposed to all quotations in all markets. The effort and expense put into the development of a communication network will be wasted if brokers are prevented by restrictive rules and practices from using that network to search out the best price for their customers.
The Subcommittee therefore recommends that Rule 394 be amended, either by the NYSE on its own initiative or at the direction of the SEC, to permit exchange members to deal net with third marketmakers, without prior permission of the Exchange, subject to a requirement that public orders be given priority in the actual consummation of the transaction. This rule change should go into effect not later than the date on which the consolidated transaction reporting system for NYSE stocks goes into effect, but in no event later than December 31, 1973.65 The SEC rule en visions that the consolidated reporting system will be fully implemented not later than the fall of 1973. 63 House Hearings at 3370. 65 The Subcommittee notes that the SEC, in its statement on Market Structure in February 1972, called for "eliminatio i of artificial impediments, created by exchange rules or otherwise, to dealing in the best available market" as one element in the creation of a central market system. SEC, Market Structure Statement 8, reprinted in 1 Institutional Membership Hearings at 157. However, in contrast to its haste in implementing other portions of its proposals, particularly those relating to institutional membership, it has as yet taken no action in this important area.
B. WHAT KIND OF CENTRAL MARKET SYSTEM?
While there has been substantial agreement that a "central market system” for any particular stock is preferable to a number of separate unconnected markets for that stock, there is a good deal of disagreement over what the characteristics of that market system ought to be.
1. "AUCTION" AND "DEALER” MARKETS
The discussion has tended to be conducted in terms of whether the public is better served by an “auction” or a "dealer” market. However, for several reasons, this has not proved to be a very productive discourse. The OTC market in unlisted securities is largely a "dealer" market, in the sense that a professional market-maker is generally involved as a buyer or seller in each transaction. However, we have no working example of a pure "auction” market, in which all transactions are effected solely between brokers acting as agents for public customers. The exchange markets for listed securities involve a substantial portion of transactions in which the specialist or another member firm acts as principal, or are otherwise negotiated outside the Fauction" process.
On the New York Stock Exchange, for example, 45.1% of the volume in 1971 involved a member firm acting as dealer on one side of the trade. This percentage has shown a steady increase in recent years, from 28.8% in 1945 to 34.6% in 1950, to 42.4% in 1960, to 44.2% in 1970.2 Member participation on the AMEX has shown a similar pattern, increasing from 26.9% in 1945 to 47.1% in 1970.3
The question, therefore, is not whether the public is better served by an "auction" or by a "dealer” market, but what features of those two markets should be preserved in the developing central market system.
2. GOALS OF A CENTRAL MARKET SYSTEM The preceding section focused on the steps to be taken in developing the communications network which will be the heart of the central market system. The focus of this section is on the content of the regulation that should govern the participants in that system.
In deciding who should participate in this central market system for listed securities, and on what terms, the Subcommittee is concerned not with the preservation or elimination of any particular entity or group of firms, but with the interests of public investors,
1 The confusion as to what constitutes an "auction" market is illustrated by the testimony of a Vice President of the NYSE during the SEC hearings on market structure in 1971. Donald L. Calvin testified that he would consider the London Stock Exchange to be an "auction" market, even though brokers do not deal directly with each other, but only with a "jobber”, who acts as a dealer on one side of each transaction. SEC Transcript of Proceedings in the Matter of the Structure, Operation and Regulation of the Securities Markets 1127, 1141-42 (Oct. 22, 1971). 2 See NYSE 1972 Fact Book 73, 75; Testimony of Donald E. Farrar, 6 Study of the Securities Industry: Hearings Before the Subcommittee on Commerce and Finance of the House Committee on Interstate and Foreign Commerce, 92d Cong., 2d Sess. (1972) at 3049 (hereinafter cited as "House Hearings"). 3 AMEX, Databook 36 (1971).
both those who invest individually and those who invest through the medium of institutions. In the Subcommittee's judgment, investors in listed securities have two paramount interests:
(1) The maintenance of stable and orderly markets with maximum capacity for absorbing trading imbalances without undue price movements; and
(2) Centralization of all buying and selling interest so that each investor will receive the best possible execution of his
order, regardless of where it originates. These interests are the same as those identified by the SEC in its Statement on the Future Structure of the Securities Markets in February 1972.
3. CHARACTERISTICS OF PRESENT MARKETS
As noted in Section A.1 above, trading in stock issues listed on the NYSE, which accounts for well over half of all stock trading and encompasses the shares of most of the nation's largest companies, is currently divided among a number of markets—the NYSE, several regional exchanges, and the "third market." 4 This division of markets of course has a substantial effect on the manner in which the goals identified above are now being met.
Each exchange now has procedures by which every order, including those negotiated off the floor, is required to be brought to the floor for execution and must yield precedence to existing public limit orders on the specialist's book. There is, however, no formal interchange of information between the various exchanges, so that orders executed on one exchange can "by-pass” public orders on the book, or represented by brokers on the floor, of another exchange. Orders executed in the third market" are not reported, and can by-pass orders pending on any of the exchanges.
Development of the composite transaction reporting and quotation systems described in the preceding section will make possible the reporting of all transactions, and the exposure of all buying and selling interest, in a single facility. The problem to be addressed in this section is the regulatory approach to assuring that this is done. However, the Subcommittee does not believe that centralization of buying and selling interest should involve sacrificing the marketmaking strength which would be obtained by requiring the inclusion of all competitive market makers in a single system. Public investors will derive little comfort from the precedence given to their orders if the market in which those orders are executed lacks the depth and liquidity to absorb the pressures of trading.
The essence of a public market is the flowing together of public orders for matching. A market which is characterized by regularity and reliability of operations and which is not characterized by wide price swings within relatively short spans of time is an "orderly": market as that term is used in the Exchange Act. An "orderly" market is also one which has "continuity," i.e., minimum price variations or deviations between transactions in a series of consecutive separate transactions, and "liquidity," i.e., the ability of a willing
See SEC, Report of Special Study of Securities Markets, H.R. Doc. No. 95, 88th Cong., 1st Sess. pt. 2, at 870 (1963) (hereinafter cited as "Special Study").
seller to readily (or perhaps immediately) find a buyer, or vice versa, at a mutually agreeable price.
Because there are frequent temporary imbalances in supply and demand arising from the absence of matchable orders on the other side, if the securities markets are to remain orderly there is a need for firms which will trade for their own account, i.e., dealers, in order to supply the "other side” and compensate for temporary imbalances, i.e., to supply "Liquidity.” When a dealer is willing in this way to risk its own capital to facilitate the completion of trades by others, it is performing a market-making function.
Traditionally, the market-making function in the exchange market has been performed by the specialists. However, the increase in institutional participation in this market, including the enormous growth of block trading, has had a profound impact on both the exchange market and the role of the specialist. At the time of the Special Study, the most common way of buying and seliing listed stocks, even for institutions working on large block purchase or sale programs, was through relatively small individual executions in the regular exchange auction market with trading imbalances being offset by the specialists. The data in the Institutional Investor Study suggests, however, that at the present time institutional trading is characterized by such substantial imbalances that the specialist system as a whole is unable to offset them. Accordingly, dealer participation in the markets beyond the apparent capacities of the present specialist system has become necessary to supply liquidity with continuity to institutional size orders.
In order to satisfy their desire for liquidity for large blocks of stock !
When a block trade assembler is unable to place an entire block
system to perform the entire market-making function for institutional truding.
Substantial “positioning” capacity is also being provided by third market dealers and regional exchange specialists. The SEC's Institutional Investor Study found in 1970 that average positions of regional exchange specialists and third market makers in NYSE stocks were very substantial in relation to the positions of the NYSE specialist. Their positions were especially important in actively-traded stocks, in which third market dealers held 28 percent of the total dealer inventories and regional exchange specialists an additional 15 percent.11 In other words, in those NYSE stocks, about 43% of the overall dealer positions were being carried by market-makers operating outside the NYSE.
The question to be addressed in this section is how fullest advantage can be taken of the various sources of market-making capacity now available to add depth and liquidity to the market for equity securities. The importance of, and the potential for, supplemental marketmaking strength in lending stability to the markets is illustrated by the trading in the stock of Occidental Petroleum, one of the most active NY SE-listed issues, in July 1972, following the company's announcement of a large trade agreement with the Soviet Union:
On Monday, July 17 rumors of a deal between the Company and the Russian Government, hit the Street. Trading on the New York Stock Exchange was halted at 12:13 after 162,000 shares had been traded. The closing price was 1234 up 7 from its previous quote. According to Exchange officials, the reason trading was halted was the enormous influx of orders, which simply overwhelmed the specialist.
On Tuesday, Occidental was finally cleared for trading on the NYSE at 2:04 P.M. by which time the Exchange had finally been able to match Buy and Sell orders. Over a million shares of the stock changed hands and it ended the day up 234.
On Wednesday, Occidental didn't open until 1:04 P.VI. when a single block of 612,000 shares crossed the tape at 1658. Fifty minutes and 699,300 shares later, trading was again halted, due to the specialist's inability to handle the flood of orders. On Wednesday also, the Exchange announced that it had banned stop orders in Occidental securities and that, effective, Thursday, 100 per cent margin would be required on all purchases of the stock.
Meanwhile, in sharp contrast to the NYSE's difficulties, other markets were able to maintain orderly, continuous trades in Occidental's stock. The Philadelphia-BaltimoreWashington Stock Exchange, particularly, won itself many new friends by the efficiency of its operations. On Monday 85,000 shares changed hands, opening at 1312 and closing at 147. On Tuesday, 302,000 Occidental shares were traded on the P-B-W which was more than either the Pacific Coast Exchange (98,700 shares) or the Midwest Exchange (232,900
shares) handled and almost as much as both combined. 11 Id. at 1956.