Witness Large Changes at the Big Board

Physician's Money Digest, December31 2003, Volume 10, Issue 24

It all started when the SEC asked the New York Stock Exchange (NYSE) in the summer of 2003 to disclose the excessive amount it was paying its chairman and CEO, Dick Grasso. Charges followed that the NYSE board of directors had been lax in monitoring the chairman's complex pay package. In mid- October, the NYSE announced it would punish five floor-trading firms for improper trading and assist the SEC in its broad investigation into the abuse of trading rules. Since then, the exchange has become an epicenter of disagreement and scrutiny among regulators, members, and the exchange itself.

Big Money Scrutiny

As a self-regulatory agency, the NYSE ensures that its members comply with its rules and federal securities laws in trading selected securities. The exchange is operated by a board of directors made up of public representatives and officers of member companies. Despite the long history of exchange members serving on the board, the practice has come under scrutiny by investors and politicians. The con- flict centers on the possibility that a director could participate in investigating or punishing a firm in which they have a financial interest or even direct control.

When former Citigroup Chairman John Reed assumed office as the NYSE's interim chairman, he declared plans to recast the exchange's governance structure, wrestle with the apparent conflicts of interest in its regulation, and serve only on a transitional basis—at a symbolic $1 salary—while he helped search for a permanent replacement. Reed and SEC Chairman William Donaldson, who ran the NYSE in the 1990s, have both said that although the current system is flawed, it would be a mistake to split the exchange from its regulatory arm.

Trading Places

At the heart of problems surrounding the exchange's trading practices is its use of specialists (ie, individual floor traders who must facilitate orderly trading of specific stocks and sometimes trade from their own firms' accounts when there aren't enough investors to effect trades). Trading on behalf of one's own account is a privilege afforded only to specialists. While this is required for specialists to meet their responsibilities, it carries a potential con- flict of interest. The SEC and NYSE investigations probed practices that include illegal "frontrunning" and "interpositioning," in which specialists attempt to unfairly profit from customers by trading for their own firms before customers.

In recent years, there has been pressure to replace the human aspect of NYSE trading with an electronic system. The NYSE's well-known auction system, in which brokers gather before a specialist on the trading floor, shouting back and forth to attain the best price, is unique among the world's major stock markets.

The Nasdaq employs electronic systems whereby bid and ask prices are posted electronically, with no third-party influence. Institutional investors favor electronic systems' speed and anonymity. Detractors say that smaller investors may not always get the best price. Instead of specialists, the Nasdaq uses market makers to bring liquidity and stability to the market, and operates under different rules than the NYSE. Exactly what changes will pan out at the NYSE remain to be seen.

Scott J. Kleiman is the president of Apollonia Financial Services in Elkins Park, Pa. All securities offered through Linsco/Private Ledger, member SIPC. Past performance is no guarantee of future results. The information presented is the opinion of Scott J. Kleiman and not Linsco/Private Ledger. Mr. Kleiman welcomes questions or comments at 800-242-1760 or info@apolloniafs.com.