able to determine—for that situation—whether a fair and

orderly market has been maintained.72 In response to the Martin Report's call for "clearly defined performance criteria against which all specialists should be judged,” the NYSE, early in 1972, developed a new set of more "objective” measurements of specialist performance, involving the application of complex mathematical formulas as well as questionnaires asking floor brokers to evaluate specialist units on a variety of criteria. However, the Exchange has specifically stated the new system will not establish satisfactory levels of performance”, but will "only compute comparative levels around an average.” While the Exchange expected that the new system should "ultimately ... provide the Floor Affairs Committee with a sounder basis for recommendations as to allocating new issues . . . initially, its main purpose is educational.” 73

Aggravating the absence of clear criteria for evaluating specialist performance is the absence of any public disclosure of the standard by which new stocks are allocated. And despite statements by the SEC as to the significance of the allocation procedure,74 that agency has made no inspections of the NYSE's records of how the allocations have been made.75

These many serious obstacles to improvement of the markets through regulation of the performance of a single exclusive marketmaker have led inevitably to the conclusion that competition among market-makers will be a more effective spur to improved markets. As Dr. Donald E. Farrar, Director of the SÈC's Institutional Investor Study, pointed out in a recent article:

Some persons evaluating the study's evidence have concluded that greater capital requirements and tighter regulation are necessary to improve the functioning of the specialist system. Others prefer greater competition between specialists and other market-makers. The evidence in the study strongly supports the latter position. Shortage of capital is simply not a credible explanation for faulty performance by specialists earning annual rates of return in the neighborhood of 200%.

Regulation would offer a tenuous basis for improving the performance of a monopolistic specialist system. Regulation at best can establish only minimal standards of performance. Once the system is working, regulation tends to be more effective in punishing misconduct than in motivating participants to take steps to improve the system's performance. It is one thing to prevent a man by rule from beating his wife; it is quite another to try in the same way

to require him to be kind to her.76 On the basis of a review of its staff study of the regulation of the specialist system, as well as the findings of the Institutional Investor Study and the other materials referred to above, the Subcommittee is forced to the conclusion that regulation and exhortation of a single 72 4 Study Hearings at 109. 73 4 Study Hearings at 153. 74."[T]he heart of specialist regulation is in the nature of the assignment and reassignment of specialist books." SEC Comments on Staff Study of Regulation

of Specialists, 4 Study Hearings at 66. 75 4 Study Hearings at 34-35. 76 Farrar, The Coming Reform on Wall Street, Harv. Bus. Rev., Sept.-Oct. 1972, p. 115.

market-maker will not be adequate to provide stability and continuity in the markets for listed securities. Ito assure markets adequate to serve individual and institutional investors, encouragement must be given to all groups of market-makers to make simultaneous competing markets in each security within the new central system.

This is not to suggest that competition would remove the need for any regulation of market makers. The Subcommittee believes that all market makers in listed stocks should register as such with the SEC and that those purporting to make continuous markets in particular stocks should be subject to an obligation to make continuous and orderly markets in those stocks. Such a requirement was in fact supported by a leading representative of the third market in recent testimony." While the Institutional Investor Study found that all three types of market-makers (NYSE specialists, regional exchange specialists and third market-makers) normally tend to behave in a stabilizing manner and thus reduce the size of the price fluctuations that would otherwise occur,” 78 the Subcommittee believes that regulatory authority should be available to back up the competitive pressure to make tight and continuous markets. This regulation in support of competition would be considerably easier to administer, however, than the present system under which regulation is designed to substitute for competition.

Regulation of al) market-makers does not mean, as some have suggested,79 requiring all market-makers to become members of exchanges. While some concept of "membership’ in the entity administering the central communication system may be appropriate, membership in an exchange modeled after the NYSE in its present form involves acceptance of significant restrictions on the manner in which third marketmakers presently conduct their business. Chief among these are their ability to choose the stocks in which they make markets and to deal directly with institutions without charging a commission.80 As noted above, the Subcommittee does not believe a case has been made for subjecting all market-makers to restrictions of this nature.


a. Characteristics of Listed and Unlisted Issues

The foregoing discussion is focused on those securities which are now traded on exchanges. There are a substantial number of stocks now traded only in the OTC market which, in terms of trading volume, stability of the issuer, availability of information, and other factors, are fully the equal of most of the issues listed on the NYSE and AMEX. In fact, 470 stocks traded only in the OTC market meet Federal Reserve Board margin requirements which are more stringent than the requirements for listing on the AMEX or any regional exchange. 31 Recent figures showing annual volume in issues traded on the NYSE, AMEX and NASDAQ also show that there are many OTC (NASDAQ) issues which have trading volume equivalent to that of most of the issues traded on the two New York exchanges. In fact, as the following 77 See Testimony of Donald E. Weeden, 7 House Hearings at 3568. 78 4 Institutional Investor Study at 1956. 79 See 1 Institutional Membership Hearings at 137, 138. 80 A leading third market representative testified that “we would like to be able to make a market in all of those securities in which we think we have the capability of making a market. We would like to offer the Institutions a net price without commissions if they wish to deal in that way.” Testimony of Donald E. Weeden, 7 House Hearings at 3617. 81 Galle, NASDAQ's Impact on the Listing Decision, Investment Dealers' Digest, July 25, 1972.

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table shows, there are three times as many NASDAQ issues trading over 5,000,000 shares a year, and twice as many NASDAQ issues trading over 1,000,000 shares a year, as there are AMEX issues trading at those levels of volume. 82

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On the other hand, the suggestion has been made that not more than 600 to 700 of the 1,400 stocks listed on the NYSE are really suitable for auction trading:53 A regional specialist testifying at the recent House hearings set the figures even lower, suggesting that "there are probably some 200 or 240 desirable trading vehicles" among them.84 In this connection, it is interesting to note that the 213 NYSE issues which traded over 5,000,000 shares in 1971 accounted for 49.2% of total volume, and the 241 AMEX issues which traded over 1,000,000 shares in 1971 accounted for 62.6% of the volume on that exchange.85

Since auction trading depends on a continual flow of transactions, the Subcommittee asked the SEC to determine the numbers of transactions on the NYSE in each listed stock for a single trading day. On the basis of an analysis of all common stock issues traded on March 15, 1972, a 19.4 million-share day, the SEC determined that 26% of the issues had fewer than 9 trades, 49% had fewer than 17 trades, and 75% had fewer than 33 trades. On the other hand, the range of activity at the top end of the scale was substantial. For example, there were 249 trades in AT&T, 526 in Occidental Petroleum, and 535 in Thiokol Chemical. Clearly, the characteristics of the market for å stock in which there are more than 500 trades in a single day are quite different from one in which there are fewer than 10 trades. 86

A further indication of the wide variation of market characteristics of listed stocks is the degree of specialist participation required to support the "auction" market in the most active and least active issues on the NYSE and the AMEX. About 50% of the member trading on the NYSE, and 67% of the member trading on the AMEX, consists of purchases or sales by specialists for their own account.87 The participation rate of specialists varies from stock to stock, being considerably higher in less active issues. The following table shows the percentage of total volume in the 50 most active and 50 least active common stock issues on the NYSE and on the AMEX in which the specialist was a buyer or seller for his own account. It can be seen that, on average, while the specialist participates as principal in only about a quarter of the trades in the most active issues, he

82 Figures supplied by NYSE, AMEX and NASD. (NASDAQ figures annualized from figures for 13week period ended Dec. 1, 1972.) 83 See 6 House Hearings at 3062. 84 Testimony of David

B. Heller, 7 House Hearings at 3559. 85 Information supplied by NYSE and AMEX. 88 Information supplied by SEC. 87 NYSE, 1972 Fact Book 11; AMEX, Databook 37 (1971).

participates as principal in more than half the trades in the least active issues.

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The fact that the less active issues presently listed on exchanges require a higher degree of dealer participation makes them considerably less desirable to specialists then the more active issues. In fact, it appears that the ability of the exchanges to allocate stocks to specialists on the basis of their demonstrated capabilities is limited by the need to give each specialist unit some "desirable” stocks to offset its "undesirable” stocks. One specialist, testifying at recent hearings, said that “one of the burdens in the system, talking as an exchange specialist, is that there are undesirable securities that you have to trade," and that "on the Midwest Stock Exchange you can find approximately 150 stocks which were put in the closet, or more crudely, in the can, where no one will make a market in the stocks." 89

A Pacific Coast Stock Exchange specialist, at the same hearing noted that on the PCSE and on the NYSE, "just within the last month or two, there have been a couple of stocks that specialists have given up on," and questioned whether "the current idea on the exchange of forcing the specialist to give this artificial liquidity or artificial narrow spread is a realistic one.” 90 He also expressed agreement with the suggestion made by a third market maker for an experiment to let specialists drop "undesirable” stocks on the assumption that there will usually be "somebody ready and willing to take that stock up."

The former Associate Director of the Institutional Investor Study questioned the "theory that specialists might be willing to do a better job in making markets in some stocks because they have very attractive stocks on the other side."

That means there is a subsidy from one class of stockholder to another. I think every stock should have as good a market as it deserves at that time. There may be some stocks that don't deserve to have a good market. There is not a good public interest or everybody wants to sell it at a given moment.

In that case it will be a lousy market. But that is a market. Why should somebody feel he has an obligation to take losses on this stock on the basis of some business that is more

profitable in another security. 88 Total volume divided by total specialist purchases and sales. Figures supplied by NYSE and AMEX. 89 Testimony of David B. Heller, 7 House Hearings at 3558, 3559. 80 Testimony of William A. Lupien, id. at 3560.

I can see from the point of the exchange community, if you have a limited group of brokers, that it makes sense to do this from the point of view of the brokers and the business they attract by having monopolization on access to trading of a broad group of stocks and you never know from one day to the next which one is going to be attractive, but why it is in the general interest to have one stock subsidize another escapes me.

I think market makers should have the right to compete in a stock when it is attractive to them and they should have a right to stop marketmaking when it no longer makes sense

to them. 91 In a competitive market-making environment, stocks will attract the kind of market that is warranted by their trading characteristics. If a particular stock does not attract sufficient investor interest to support an “auction” market, it is hard to see why any dealer should be obligated to subsidize an "artificial” market in that stock out of his profits from exclusive trading rights in a more "desirable" stock. Many stocks which were "listed” because of great public interest at the time may no longer attract such interest. The needs of public investors will be best served by greater flexibility in permitting each stock to trade in the combination of auction" and "dealer" markets that best accords with its trading patterns.

As stated above, the Subcommittee believes that all investors in publicly-held companies are entitled to the best market available, given the characteristics of the particular stock. Investors in stocks traded only in the OTC market do not now enjoy the benefits that may arise from permitting public limit and market orders to meet inside the dealer spread. The decision whether or not to "list" a stock for trading on a stock exchange is presently vested in the company's management, and reflects the historical pattern whereby a stock was traded either on an exchange or in the OTC market, but not in a combined central system. b. History of Unlisted Trading Privileges"

At present, nearly all the stocks traded on exchanges are there because the management has been persuaded to "list" them on at least one exchange. This has not always been the pattern. Each exchange has started by simply trading stocks in which its members were interested, and has moved to a system of contractual listing only as its market has developed sufficient prestige to induce corporate managements to incur the expense and other commitments of listing.

The NYSE was the first, and is still the only, exchange which trades exclusively "listed” securities, having eliminated the last unlisted trading privileges in 1910.92 As recently as 1945 a majority of the stock issues traded on the AMEX were unlisted, and 57 issues trading on that exchange are still unlisted,93 including such active issues as Creole Petroleum, Imperial Oil and Prentice-Hall.94 The great majority of the securities traded on the regional exchanges are 91 Testimony of Seymour Smidt, id. at 3561-62. 92 2 Loss, Securities Regulation 1133 (1961). 03 AMEX, Databook 27 (1971). 94 Information supplied by AMEX. See Cedar, “Unlisted" Stocks on the AMEX, Comm'l. & Fin. Chron. Oct. 12, 1972.

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