Allegations of trading improprieties by New York Stock Exchange floor specialists are heating up the debate over replacing floor trading with increased automation.
"We have been concerned, along with other firms, for years about possible front-running at the NYSE," said the head trader for a large institutional money manager, who requested anonymity.
"In the last two or three years, the economic model on the floor of the NYSE has been under stress. Decimalization has reduced spreads and commissions, and overall volume has declined."
He said "the problem ultimately is with the model itself. The NYSE floor option model has multiple levels of human interaction. There are alternative ways to trade, and we see the electronic model growing around the world. A technology-driven electronic exchange is the only way to completely eliminate these problems - to dramatically and aggressively change the model to increase the level of technology. In the most dramatic sense, you eliminate the whole specialist role."
Backed by buy side
Buy-side traders increasingly support that model, said Andrew Goldman, executive vice president at Instinet, a New York-based electronic communications network.
"There is an inherent fundamental conflict with a floor-based model," said Mr. Goldman. "With specialists, there is a unique time/place advantage by certain individuals with unique access to prices and trading information. The self-regulated organizations (like the NYSE) are prone to misuse."
He said accusations of front-running by floor specialists should serve as a catalyst to reforming the floor model at the NYSE, just as a similar scandal at the Nasdaq opened the door for more electronic venues and the development of ECNs in the late 1990s.
Others wouldn't overhaul the NYSE, but agree there will be added pressure to make changes.
"It's not obvious to me that that the specialist system is broken. I'm obviously an advocate of electronic trading, but the notion of saying let's replace everything (at the NYSE) with an electronic marketplace ... that needs to be thought out very carefully, especially with regard to commitment of capital to maintain an orderly market," said Ian Domowitz, managing director of product management at ITG Inc., a New York-based provider of equity trading services and transaction research.
Steve Nesbitt, senior managing director of Wilshire Associates Inc., Santa Monica, Calif., agreed efforts could intensify to automate more trading functions.
NYSE officials announced April 17 they had initiated a review of trading practices of some floor specialists to determine if specialists took advantage of their unique positions in certain stock transactions. But some market observers point out that the activity being investigated is not new. Specialists help match buyers and sellers on the exchange floor and use their own capital to buy or sell shares to prevent imbalances.
Officials of the New York Stock Exchange issued a strongly worded statement last week that its investigation does not involve front-running, but rather "possible violations of the specialist's `negative obligation.' " The NYSE statement said "negative obligation" requires specialists to "provide an opportunity for public orders to be executed against each other within the current market and without undue dealer intervention. In other words, the specialist must `stand out of the way' when a natural match can occur between buyer and seller."
Industry experts say the exchange's terminology is largely semantic, because the end result is that rather than "stand out of the way," specialists might have used their position to "step in front" of customer orders to generate commission income.
The NYSE "is using a strict legal interpretation in its definition," said one market analyst. "That's the first time I've ever heard the term (negative obligation). This may not be the classical definition of front-running, but it is still stepping ahead of customer orders by specialists."
"Apparently some specialists were acting as agent and principal but stepping in front of some orders and executing orders in their own accounts first," said a market researcher who requested anonymity. "They may have put some of their own principal orders ahead of agency orders."
Institutional asset managers "could be hurt" if the practice is widespread, he said. "You would end up paying a higher price when buying or selling at a lower price, or experiencing unnecessary delays."
He said one possible solution is to prohibit floor specialists from serving as both agency and principal brokers, and to "draw a distinct and unmistakable line" between the two.