Moreover, on a monthly basis the dollar amounts of these
net trading imbalances appear too large to expect market
makers alone to bridge the time gaps between institutional
orders by inventorying the stock. It does not seem feasible
to segregate institutions into a separate trading market

wholly apart from other investors.29 In view of this finding, and of the obvious technical and definitional problems in attempting by governmental action to "separate” the markets for “individuals” and “institutions”, the Subcommittee believes that efforts should be concentrated on improving the structure of the markets and of the securities industry, as outlined in other parts of this chapter, so that they can adequately serve the needs of both individual and institutional investors. Although individuals tend to engage in smaller transactions and to transact business through brokers, while institutions tend to engage in larger transactions and to deal in many cases directly with market-makers, there is no reason why an industry composed of firms offering different kinds of services under a flexible price structure cannot adequately accommodate both of these needs.

iii. Improved Market-Making Capacity

As noted above, one step taken by the SEC pursuant to its Market Structure Statement was the appointment of three industry advisory committees to make specific recommendations for implementation of the SEC proposals. In August 1972, the Industry Advisory Committee on Block Trading submitted to the SEC its recommendations for strengthening "the ability of the market to absorb large blocks of stock on a reasonable basis.” Among other things, the Committee recommended:

1. Vodifying or repealing NYSE Rule 113 30 and permitting institutions to have their identity disclosed to the specialist, thereby enabling the specialist to explore directly the size and timing of blocks coming into the market;

2. Modifying or repealing NYSE Rule 438 31 and permitting block positioners, on an experimental basis, to register as "upstairs market-makers” in particular securities;

3. Modifying or repealing NYSE Rule 394 32 and permitting specialists to work with all block traders in processing orders:

4. Allowing pre-existing public orders to displace block transactions in any sale below the bid or purchase above the asked price currently quoted by the specialist (but rejecting suggestions for prior announcement of block transactions to

permit displacement by additional public orders); and 29'Id. at 1461. 30|

NYSE Rule 113 provides in part: “No specialist . . shall accept an order for the purchase or sale of any stock in which he is registered as a specialist directly.... from any institution, such as a bank, trust company, insurance company, or investment company."

31 NYSÉ Rule 438 provides in part: “Members ... may not publish actual prices of bids and offers and may not show both “bid wanted" and "offer wanted" with respect to the same security on the same day.” No judicial challenge has yet been

made to this rule, and it is therefore impossible to state what regulatory justification may be offered to prevent a declaration of its invalidity under the antitrust laws. See Chapter III. E. below.

32 NYSE Rule 394 provides in part: “... members . . . must obtain the permission of the Exchange before effecting a transaction in a listed stock off the Exchange, either as principal or agent.” See Section A.2.c. above.

5. Continuing the specialist “as the focal point for the reporting of all transactions, to assure the interface between large and small transactions and to coordinate large transac

tions with the protection of the small public investor.” 33 The Subcommittee believes that the approach outlined by the SEC, Advisory Committee is the most constructive plan thus far advanced for integrating -auction" and "dealer” markets, and institutional and individual trading, in a single system in which the rights of all investors will be adequately protected. It envisions the removal of present restrictions on coinmunication between market-makers and maximum opportunity for competitive market-making, combined with protection of the priority afforded public limit orders in an "auction” market system. While the Subcommittee does not necessarily endorse all of the specific recommendations in that report, it is an appropriate starting point in considering the decisions the SEC must now make to define the outlines and procedures of the new market system.

Although the process of market-making in listed securities has changed dramatically since the passage of the 1934 Act, the Subcom-' mittee does not believe any amendment of the Act is required to : permit either the present activities or the types of activities contemplated in the proposal of the Block Trading Advisory Committee. If undue impediments represented by Exchange rules are not removed by Exchange or SEC action, however, the Subcommittee will consider legislative action to remove them. c. Regulation of the Ictivities of Market Makers

The official recognition of the participation of all classes of marketmakers within a single system will require that attention be given to the source and nature of the regulation that will govern their activities. The SEC, in Varch 1972, delegated the task of initial policy formulation in this area to an Industry Advisory Committee on a Central Market System. Despite the broad sweep of jurisdiction indicated by its title, the Advisory Committee has focused on relatively narrow questions. Its sole specific recommendation thus far has been for a rule regulating short sales in listed securities by a l brokerdealers.34 Even on this limited question, its report noted differences and misgivings among its members as to whether a single rule on the subject would make sense in different types of markets with different characteristics.

The Subcommittee does not believe that differences within the industry over "equal regulation” of dealers should be permitted to impede development of the consolidated reporting and quotation systems which are the heart of the new central market system. The regional exchange specialists, third market-makers and block positioners have been operating as alternative market-makers for some time now, each operating in a distinctive manner to meet particular market needs. The SEC has always had a responsibility to prevent members of any of those groups from using their access to the markets

33 Report to the SEÇ, dated Aug: 7, 1972, by the Advisory Committee on Block Transactions, reprinted in BNA, Sec. Reg. & L. Rep. No. 166, at D-1 (Aug. 23, 1972),

34 Interim Report of the Advisory Committee on a Central Market System to the SEC on Regulation Needed to Implement a Composite Transaction Reporting System (Oct. 11, 1972), reprinted in BNA, Sec. Reg. & L. Rep. No. 173, at 1-1 (Oct. 18, 1972).

to achieve unfair advantages over public investors. As the barriers to their interaction with each other and with the NYSE floor are progressively eliminated, further possibilities of abuse will undoubtedly arise, and the SEC should deal promptly with them at that time. On the other hand, increased exposure and competition should remove many of the present opportunities for abuse, and tin SEC should be equally alert to eliminate rules and restrictions that may no longer serve a valid regulatory purpose.

In this connection, it is instructive te note the results of the inclusion of third market quotations for listed securities in NASDAQ. The Subcommittee's case study of that subject noted the strong objections of the NYSE and AIIEX against permitting quotations of listed securities in NASDAQ, and their predictions of the adverse results that might ensue.35 The study conducted by the NASD over two three-month periods after the "experimental” inclusion of such quotations in the system found that:

no deleterious effects on the general market structure have
been observed following inclusion of exchange-listed issues in
NASDAQ. The NASDAQ third market makers handle blocks
with no more disturbance to prices, and sometimes less, than
occurs on the NYSE. Less than 10 percent of large trades
(5,000 shares or more) by market-makers are executed on ex-
changes. Short sales by customers to market-makers are mini-
mal. Short sales by market-makers on regional exchanges
represent about the same proportion of total transactions as
in the over-the-counter market. And, short sales by the third
market-makers are generally at a price above the last price on
the primary exchange. The willingness of third market-
makers to sell short in response to buy orders contributes to
the stability of the market by offsetting balances between
the arrival of buy and sell orders. No short sales were effected
by market-makers on the primary exchange for the NASDAQ

included issues. 36 The lesson to be derived from this experience is that predictions of catastrophic consequences of new developments are often made by those who feel that their interests would be adversely affected by the change. It is neither necessary nor possible to write all the rules to govern the operation of the new central market system before that system has gone into operation. In this as in other areas, experience will be the best guide to what kinds of regulation are required to protect the interests of public investors.

The purpose of integrating all market makers into a single system is not to make them all do business in the same way, but rather to enable public investors to take fuller advantage of the distinctive contributions that each group can make.

For example, one of the key functions currently performed by all market makers is taking positions to facilitate the disposition of substantial blocks of stock by institutions. NYSE specialists are prohibited by Rule 113 from dealing directly with institutions, but can and do take positions in the stock when approached by brokers 35 3 Study Hearings at 9. 36 NASD, The NASDAQ-Third Market Study 1 (1972).

representing the institutions. Block positioners who are members of the NYSE deal directly with institutions, but are required to charge an amount denominated a "commission" on all transactions, even as to any part which they buy or sell as principal for their own account. Third-market-makers deal directly with institutions, quoting a net price and charging no "commission.”

Creation of a central market system does not require that all three categories of market makers be required to do business in the same way. The SEC's Industry Advisory Committee on Block Trading recommended repeal of Rule 113 to permit specialists to deal directly with institutions.37 Specialists themselves are divided on the issue, however,38 and the SEC's job is to determine whether the distinctive responsibility of the specialist in handling public orders left on the book will be seriously compromised if he is permitted to deal directly with institutions. This does not mean, however, that institutions should be barred from dealing directly with other market makers even if it is concluded that they should not have direct access to the specialist. As the former Chief Counsel-Markets of the Institutional Investor Study recently testified at hearings in the House:

Arguments have been made that there should be required interpositioning of agents between dealers and customers. For individual investors there is a virtue in separating the broker and dealer functions. Dealers have a special incentive for overreaching when they are marketing their own positions. The protection of an independent agent between the dealer and an unsophisticated investor is important. Sophisticated investors, on the other hand, are able to fend for themselves. Institutions deal directly with market-makers in government bonds, municipal bonds, corporate bonds and unlisted stocks. There is no reason to treat listed stocks differently. This is not to say that institutions should be prohibited from using agents in listed securities. The Institutional Investor Study found that they frequently do so in the over-the-counter market when they are not familiar with the market in the security or the particular market-maker or wish to preserve their anonymity. But there is no necessity to "protect” the sophisticated institution by requiring the interpositioning of an agent that it does not need or want. Institutions should be allowed to deal directly with market makers in listed securities just as they deal with block positioners today. Such direct dealing is necessary if market-makers and other

dealers are to perform their important stabilizing While one witness in the House hearings raised the possibility of an unexplained “conflict of interest” if institutions were permitted to deal directly with market makers, 40 another witness at those hearings indicated that the real reason for prohibiting direct dealing was to preserve commission income for brokers.41 If the fear is that institu37 See note 30 above. 38 See Testimony of Stephen M. Peck, 7 House Hearings at 3645; Testimony of Frank C. Graham, Jr: 39 Testimony of Donald M. Feuerstein, 6 House Hearings at 2965–66. 40 Testimony of David B. Heller, 6 House Hearings at 3647. 41 Testimony of Richard A. Westcott, 7 House Hearings at 3120.

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tional managers would feel an obligation never to deal with brokers if they were permitted to deal directly with market makers, the findings of the SEC's Institutional Investor Study do not bear it out. That study found that:

[I]nstitutions such as pension funds and foundations which
trade for their own account more often availed themselves of
the services of an agent when executing orders in OTC stocks
than did those institutions acting in a fiduciary capacity.
These self-managed accounts with their unem cumbered best
business judgment decided that the payment of an agency
commission resulted in an advantage to them over dealing
directly at net prices with the market-maker. The use of such
agents, they believed, supplied them not only with better
executions but also with valuable services such as research.
Fiduciaries, on the other hand, fearing accusation of illegal
interpositioning have tended to avoid the use of such agents

except under unusual circumstances. 42 To the extent that this factor inhibits the legitimate use of brokers, the Subcommittee believes that the effective way to deal with it is by legislation clarifying the ability of institutional managers to pay commission dollars for worthwhile services, 43 not by requiring institutions to use brokers on all their transactions.

The Subcommittee believes that the first order of priority in creating a central market system, as suggested by the SEC Advisory Committee on Block Trading, is to break down the restrictions which now impede contact between markets and market-makers. This can be done by including all classes of market-makers in a single quotation dissemination system and enforcing the obligation of brokers to seek best execution of their customers' transactions. At the same time, as recommended above, all market-makers should be prohibited from executing transactions in listed stocks without checking all public orders on specialist books and yielding priority to those orders. This will assure the public the protections of an "auction” system combined with the financial strength of a competitive dealer market.


5. OPPOSITION TO THE CENTRAL MARKET SYSTEM Progress toward the goals identified by the Subcommittee and the SEC is now being threatened by opposition within the industry, particularly as represented by the NYSE, to the development of a central market system. While the NYSÉ strongly supported the portion of the SEC's market structure statement which proposed the elimination of institutional membership on regional exchanges, it has opposed the SEC's efforts to create a unified market system featuring active competition between the present exchange and over-the-counter components.

As noted in Section A. above, the NYSE, in testimony before the Subcommittee in October 1972, stated that it was "committed” to "the goal of a central exchange system” from which the third market

42 Testimony of Bernard H. Garil, 2 Institutional Membership Hearings at 633; see 4 Institutional Investor Study at 2256.

43 Provisions to effect such clarification were contained in Sections 3 and 4 of S. 4071, 92d Cong., 2d Sess. See Chapter I. C. above. 44 See Chapter I.C. above.

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