NYSE Hybrid Proposal Strikes Compromises; Approval Likely, But Not All Are Happy

Traders Online: Gregory Bresiger: " Passage of the New York Stock Exchange's much amended market plan now appears likely. The Big Board filed a "non-substantive" seventh amendment to the plan last month. That plan mainly supports those exchange rules affected by the sweeping proposal intended to increase electronic trading at the mostly open outcry bourse. The amendment included no further changes, leading observers to conclude the battle to reshape the exchange was over.

In an interview with Traders Magazine, Bob McSweeney, Senior Vice President of the New York Stock Exchange's Competitive Position Group, stated that the final plan will satisfy traders and predicted that it will be the last one required by regulators.

"We believe that we are balancing incentive for liquidity providers and liquidity takers. This proposal strikes the appropriate balance," McSweeney said.

Critics

Critics of the hybrid are still upset over changes pushed through in the fifth amendment. These changes increase the power of specialists and floor brokers. Still, critics appear resigned to the likelihood of changes in the current form.

"I don't want to keep fighting this. Now let's see what happens," said Michael Buek, a senior equity trader and a principal with the Vanguard Group of Funds, which sent a critical comment letter to the SEC after the filing of the fifth amendment.

Buek complains the finished plan "still discourages us from placing limit orders. We post a displayed order and someone can still step in front of our order."

Another trading executive criticized the plan, but predicted that it would be approved. "The hybrid plan meets the letter of the regulatory law in this Reg NMS environment," he said, "but it retains the unique advantages of the specialist through an algorithm." This official has followed the hybrid amendments from one to seven.

McSweeney acknowledged disagreement. But he argued that the finished hybrid plan is a compromise.

"The amendments are responsive to feedback from our advisory committees. They are designed to enhance displayed size at the best bid and offer and to aggregate liquidity for efficient and low-cost price discovery," McSweeney said.

Privately, NYSE supporters agreed that the Big Board's historic chokehold on listed business will be riding on this plan.

Right Choice?

The wrong Big Board model could result in an exodus of customers. That's because stronger linkages and electronic standards mandated by Reg NMS will mean regional exchanges and other market centers will be in a better position to take away NYSE business, trading observers say. Indeed, NYSE clients are looking at alternatives.

"We understand that the NYSE plan can't satisfy everyone," Vanguard's Buek commented. But he also said Vanguard would wait and see how the hybrid market works. However, Buek explained that "90 percent of our orders are placed electronically and, if we can't be treated fairly, then we will go to a place where electronic orders are treated fairly."

McSweeney, recognizing that many traders are still antsy about the Big Board's changes, emphasizes that the NYSE is setting up a new hybrid advisory committee, which had yet to be named at press time. The committee will have buyside, sellside and NYSE member representation (See following story). Debate over hybrid was fairly muted until the New York published its fifth amendment this summer. That led to criticism from the Investment Company Institute, an influential mutual fund lobbying organization, and many of its constituents.

One of the more controversial features includes allowing the specialist to post hidden reserves. The amendment would also end restrictions against specialists trading for their own accounts on parity with floor brokers in the crowd and agency interest files.

The plan also details the ways that specialists would have greater opportunities to employ algorithms. Specialists, under the fifth amendment, would no longer be required to take an entire order when "supplying additional volume."

A Portion

Before this amendment the specialist had been charged with executing against all remaining trading volume. Now, he will be permitted to buy only the portion of an order that he wants. The specialist will continue to view all incoming orders before the public does, but subject to "specific limitations," according to the fifth amendment.

Nevertheless, the way the hybrid plan would retain this kind of auction/electronic market is why some members of the buyside are skeptical. For example, they are upset the plan allows hidden orders outside of the BBO to be on parity with displayed orders.

"Why can't I also post hidden reserve? Why is it only the specialist or the floor broker who is allowed to do so?" asked one buyside trader. Here are more examples of buyside red flags: The plan through its amendments also details the ways that specialists would have greater opportunities to employ algorithms.

The New York, under criticism from the buyside, tried to tone down the offending amendment. A key issue, McSweeney added, was outlined in amendment six in the discussion over how the specialist algorithm will work. For example, the specialist will be required to display 1,000 shares in the published quotes for the active stocks as a requirement for providing price improvement.

"That will create a new dynamic for supplemental liquidity while preserving a customer's ability to lower execution costs within the spread," McSweeney said. Price improvement, NYSE officials argue, is an essential part of the hybrid model.

"The balance is in the manner in which we restrict the specialist algorithm as to how it interacts with incoming liquidity," McSweeney said. "The restrictions provide a narrower range of opportunities than the conventional auction. It has limitations. These include that, if an order comes in between the bid and offer, a specialist cannot interact with that order until it is publicly disseminated in the market data," he added.

McSweeney insists that these changes impose on the specialist, "the responsibilities that we require of a dealer. They commit him to stabilizing capital and to dampen volatility and improve prices for investors who are representing orders in our marketplace."

Shortchanged?

Nevertheless, some trading industry sources contended that the last few amendments still shortchange the buyside because the specialist retains too many advantages. A trading executive said the first few amendments were fair to the buyside, but radical changes were made over amendments five through seven.

"The ability of the specialist to price improve a limit order will not be changed. That means we have to take far more risk than they do," said a buyside trading executive. He predicted that the specialist will easily take an order away from him and price improves it by two cents.

"That's just not fair to us," a buyside executive argued, adding that the specialist algorithm might be aggressively used to take orders away from competitors.

"We'll get by, but this is not good market structure," the trading executive added.

Other critics have questioned why the NYSE should have specialists at all. They argue that investors should have been able to execute orders themselves (See October and September Traders Magazine).

An executive of an NYSE floor brokerage said that he understands the criticism of specialists. But he maintains that the amendments have been written to preserve the unique nature of the auction system.

Balance the Needs

Joe Gawronski, chief operating officer of Rosenblatt Securities, said the hybrid plan amendments are designed to balance the needs of specialists with the needs of institutional investors as well as the goal of an exchange that is trying to remain competitive.

"Specialists make a difference. They're part of a system that centralizes liquidity and reduces volatility," Gawronski claimed. "Some of this criticism, quite frankly, is designed to destroy the floor. And that, I believe, would be a very bad thing because some stocks simply have lower trading costs on the NYSE," Gawronski said. He claims that leading transaction cost analysis providers support his belief. He said that NYSE plan also has more automatic execution requirements that will help institutional investors.

Meanwhile, an institutional trading executive, who criticized the hybrid amendments, conceded that the NYSE's way of re-configuring its market was logical. Ultimately the Big Board is responding to the needs of its membership, he added. And the "NYSE is not yet a publicly owned institution." NYSE executives also understand that potentially alienated buyside traders might end up sending more of their orders to electronic exchanges, this executive said.

So why is the NYSE taking the chance of potentially alienating the buyside?

The industry executive speculated that it is because the Big Board will soon have an insurance policy: It will have its own electronic platform with the acquisition of Archipelago Holdings. He also said that the NYSE-should it encounter wholesale order losses-will be ready to move quickly to change its new model if there are significant complaints from the buyside.

(c) 2005 Traders Magazine and SourceMedia, Inc. All Rights Reserved."