Revising or eliminating rules on how stocks are traded could end up costing investors billions of dollars a day, New York Stock Exchange CEO John Thain said Friday. Thain and rival stock market executives testified before the House Financial Services Committee in Manhattan.
Chaired by Rep. Richard H. Baker, (R-La.), the committee’s capital markets subcommittee met to discuss the role of specialist firms, who match buyers and sellers on the floor of the NYSE. The Big Board insists that specialists are essential to setting the best prices for shares traded on the exchange and for smoothing trading volatility, but their role has come under fire recently following charges they defrauded investors of millions of dollars through trading abuses.
Thain, along with executives from Nasdaq, Instinet and Archipelago, met to discuss market-structure issues. Each made their case for keeping, modifying or eliminating the highly-contentious trade-through rule, which requires that stock orders are channeled to the market that offers an investor the best price for buy and sell orders of stock.
Electronic markets such as ECNs, which are newer rivals to traditional markets like the NYSE, say the 20-year old rule is outdated because it doesn't prioritize the trading speed and certainty of execution their electronic markets provide. For its part, the NYSE argues the rule is crucial as it ensures investors receive the best transaction price.
Thain told the congressional panel that eliminating the trade-through rule could cost investors as much as $3 billion daily. If similar markets offer the same trade execution capabilities, the price of a trade is what matters most, he said. And given that the NYSE handles 1.7 billion shares daily, a two- or three-cent difference on a trade “can quickly add up to billions of dollars,” he added.
Nasdaq CEO Robert Greifeld told the panel that the trade-through rule effectively stifles competition in the marketplace, which ultimately hurts investors. The rule requires all markets to complete a trade at the exchange that offers the best price — often the NYSE. He said the recent settlement between regulators and specialists reveals “a structural flaw at the New York Stock Exchange," because the NYSE failed to stop the abuses earlier and has used the trade-through rule to “insulate” specialists from outside competition.
“Absolute power corrupts,” Greifeld said. “And if specialists didn’t have this absolute power in the first place they would never have been able to do harm to investors.”
The House subcommittee is expected to make a recommendation to the Securities and Exchange Commission about changes to the rule and the SEC is expected to propose a revision to it next week. Although the panel appeared undecided in its course of action, it did agree that technology that allows trading between the exchanges must be improved.
Specialists agree to settlement
Friday’s hearing came just a few days after news of a proposed settlement was reached between regulators and five large NYSE specialist firms accused of trading ahead of investors, an illegal practice known as "front-running." The five firms involved in the agreement have reportedly agreed in principle to pay $155 million in restitution and another $85 million in fines. None of them have admitted to any wrongdoing.
Thain, formerly president of Goldman Sachs, who took control of the NYSE about a month ago, has come under pressure from regulators to eliminate the barriers surrounding specialists and is in the process of introducing more automation into the exchanges’ trading system. He is also eager to repair the image of the exchange, tarnished by the forced exit of former CEO Richard Grasso last fall following an investigation into his compensation.
At Friday’s hearing, Thain outlined his plans to overhaul trading practices, including making it easier for listed companies to change the specialists that make markets in their stocks, developing metrics to assess the performance of specialists and allowing the rapid, automatic matching of anonymous buyers and sellers -- effectively offering the same trading execution found on rival electronic markets and bypassing specialists.
The changes look likely to crimp the NYSE’s specialist system, an open-outcry stock-trading system that is nearly as old as the 211-year-old exchange. Individual brokers, or specialists, manage the sale of stocks on the floor of the exchange. They are required to buy or sell shares from their own holdings to keep the market for a stock orderly and in balance.
Rival electronic trading networks have cried foul over the specialist system. They say it allows dishonest brokers to step in between transactions and skim off profits. The powerful California Public Employees’ Retirement System recently filed a lawsuit against the NYSE and its specialist firms, accusing them of widespread trading abuses.
One key factor in the specialists’ settlement with regulators is the establishment of a restitution fund, which is expected to total $155 million. The thinking, experts say, is the fund will deter investors from launching their own civil lawsuits against the NYSE and the specialist community.
“The fact that the settlement contains some restitution may eliminate the possibility that investors will come after the specialists, so we may get some closure,” said Michael Malloy, a former counsel for enforcement policy at the SEC and now a professor of law at the University of the Pacific in Stockton, Calif.
But with billions of shares traded on the Big Board each day, working out who lost what and when promises to be a technical nightmare according to Michael A. Goldstein, an associate professor in the finance department at Babson College in Massachusetts and who has served a one-year term as visiting economist at the NYSE.
“It’s possible to do this, but it means a lot of data and it will be a holy mess,” Goldstein said, adding that the tens of thousands of investors who are owed money may end up actually receiving a very small portion of the restitution pie.