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NYSE and the Specialist System

George SofianosApril 23, 2004

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Challenges facing the NYSE Erosion of traditional client base Regulation NMS proposal

Trade-through rule Access fees Sub-penny trading Market data

Electronic trading Making a “hybrid” model work Liquidity quote NASDAQ escalates the

competition Dual-listing initiative SuperMontage trading

Final rules will determine how NYSE evolves

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60%

89%

81%

69%

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Jan-

00Fe

b-00

Mar

-00

Apr-

00M

ay-0

0

Jun-

00Ju

l-00

Aug-

00Se

p-00

Oct

-00

Nov

-00

Dec

-00

Jan-

01Fe

b-01

Mar

-01

Apr-

01M

ay-0

1Ju

n-01

Jul-0

1Au

g-01

Sep-

01O

ct-0

1N

ov-0

1D

ec-0

1Ja

n-02

Feb-

02M

ar-0

2Ap

r-02

May

-02

Jun-

02Ju

l-02

Aug-

02Se

p-02

Oct

-02

Nov

-02

Dec

-02

Jan-

03Fe

b-03

Mar

-03

Apr-

03M

ay-0

3

Jun-

03Ju

l-03

Aug-

03Se

p-03

Oct

-03

Nov

-03

Dec

-03

Jan-

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b-04

Mar

-04

Erosion of traditional client base

50,000 share plus averages 2000: 85.3% 2001: 78.6% 2002: 73.9% 2003: 63.5%

Sources: Through Dec.2000 NYSE Monthly TAQ Data; Jan.2001 through Sept. 2002 FITCH Data; beginning Oct.2002 NYSE Daily TAQ Data.NYSE commons and warrants share volume reported to the Tape. All Tape hours

50,000 shares plus

Less than 4,000 shares

Q. Where have all the large blocks gone?A. To the upstairs broker-dealer market.

NYSE share of trading volume in listed stocks

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Distribution of trading volume in NYSE stocks

Other exchanges

4%

Nasdaq InterMarket

14%NYSE78%

ARCA1%

Chicago3%

3%

0.4%0.7%

10%

0%

Broker-dealers

Posit Liquidnet Other ECNsand ATSs

Seeing through Nasdaq InterMarket

Single-counted share volume, internal matches only, all hours, excluding ETFs.Liquidnet estimate from Business Week Online, January 26, 2004: 19 million shares daily, two-thirds in NYSE stocks. We

assume double-counted.Posit estimate from ITG website assuming 65% listed.

March 2004 ECNs and other ATS

remain marginal ARCA only 1% POSIT 0.7% and falling Liquidnet 0.4%

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The NYSE “hybrid” trading platform

electronic trading

floor brokers

specialists

Electronic limit order book

Symbol XYZ

Buy Qty Price Sell

Qty$33.0

41,100

$33.03

1,200

$33.02

1,000

$33.01

3,000

$33.00 3,000

2,000 $32.963,00

0$32.9

51,20

0$32.9

41,50

0$32.9

3800 $32.9

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electroniclimit orderbook Quoted

spread

Offer

Bid

Displayedliquidity

Non-displayedliquidity

NYSE Direct+® auto-ex

Figures are hypothetical.

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NYSE LiquidityQuote, 28 DJIA stocks1

15,600

6,000

15,600

6,000

10,400

10,400

0 5,000 10,000 15,000 20,000 25,000 30,000

NYLQ Bid -6c-5c-4c-3c-2c-1c

Inside Bid 1.5c

Inside Ask +1c+2c+3c+4c+5c

NYLQ Ask +6c

Shares

Liquidity in the book Additional liquidity

Inside spread, 6,000 shares: 1to 2¢

NYLQ spread, 26,000 shares: 13 to 14¢

1. We assume depth is equal at bid and ask (both at inside and liquidity quote); NYSE only provides combined bid and ask information. Data as of November 20032. Estimates from Goldman Sachs trading cost model, equally weighted, individual stock estimates range from 3¢ to 28¢ (UTX)

NYSE LiquidityQuote (NYLQ) includes 40% additional liquidity displayed by specialist and floor brokers

Goldman Sachs estimated spread2, 26,000 shares, one-hour trading horizon:

10¢

Q. How can the NYSE make LQ more competitive?

A. ?

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The value of the trading floor

99%

62%

1%

38%

0%

20%

40%

60%

80%

100%

Orders Volume

electronic book

floor brokers

Large, difficult orders choose floor brokers 40% of volume

Why use a floor broker? Non-displayed liquidity Subtle exchange of information Ability to better predict short-term alpha Ability to better time executions Direct access (independent floor brokers)

Floor brokers representing non-displayed liquidity

NYSE provides a choice Electronic book Floor brokers

Most orders choose electronic

Displayed liquidity Small, easy orders

* Source: NYSE, November 2003

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Can the NYSE “hybrid” model succeed? NYSE has all the needed ingredients

80% of trading volume Commitment to fast electronic trading for easy

flow at retail inside quote An institutional quote Relatively efficient access to non-displayed

liquidity Additional liquidity provision by specialist

How make all these ingredients work together?

Competition, pennies, electronic trading, scandals, changed the economics of the NYSE, of the specialists and of floor brokers

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The problem with the specialists systemBuy-side perspective: Large institutional investors Problem with trading through a specialist

Specialist proprietary trading and conflict of interest How is information being used?

Exactly the same problem buy-side has in trading through any upstairs broker-dealer

But upstairs broker-dealers provide a valuable service to the buy-side that counterbalances this problem

Liquidity for large difficult transactions Specialists do not provide a similar valuable service to

the buy-side Liquidity at the inside quote, to smoothen short-term fluctuations

in price Institutions that trade in large blocks do not care much for this! Perhaps good for individual investors….

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How fix it? Pull the specialist out of the inside quote Get the specialist provide liquidity where it is most

needed Large difficult trades At the NYSE LiquidityQuote?

For this to succeed must get the specialist closer to the upstairs broker-dealer desk

Chinese Walls!

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The two papers on specialist trading Roger and Jerry

Liquid stocks in specialists’ portfolios subsidize illiquid stocks Maybe a good thing but not sustainable in a competitive environment

Pooling or separating equilibrium? One of the reasons NYSE’s market share is lower for liquid stocks

Larry and Jay Emphasizes sensitivity of specialist trading behavior to the rules of

the game Resilience of specialist profitability to changes in the rules

Encouraging in the face of imminent dramatic changes Specialists are good short-term traders

Will they be able to provide liquidity to large blocks – where it is most needed?

What changes must take place to make it easier for specialists to provide liquidity to large blocks?

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