Specialists and the Execution of Trades

A specialist "makes a market" in the shares of one or more firms. This task may require the specialist to act as either a broker or dealer. The specialist's role as a broker is simply to execute the orders of other brokers. Specialists may also buy or sell shares of stock for their own portfolios. When no other broker can be found to take the other side of a trade, specialists will do so even if it means they must buy for or sell from their own accounts. The NYSE commissions these companies to perform this service and monitors their performance. In this role, specialists act as dealers in the stock.

78 PART I Introduction

Part of the specialist's job as a broker is simply clerical. The specialist maintains a "book" listing all outstanding unexecuted limit orders entered by brokers on behalf of clients. (Actually, the book is now a computer console.) When limit orders can be executed at market prices, the specialist executes, or "crosses," the trade.

The specialist is required to use the highest outstanding offered purchase price and lowest outstanding offered selling price when matching trades. Therefore, the specialist system results in an auction market, meaning all buy and all sell orders come to one location, and the best orders "win" the trades. In this role, the specialist acts merely as a facilitator.

The more interesting function of the specialist is to maintain a "fair and orderly market" by acting as a dealer in the stock. In return for the exclusive right to make the market in a specific stock on the exchange, the specialist is required to maintain an orderly market by buying and selling shares from inventory. Specialists maintain their own portfolios of stock and quote bid and asked prices at which they are obligated to meet at least a limited amount of market orders. If market buy orders come in, specialists must sell shares from their own accounts at the asked price; if sell orders come in, they must stand willing to buy at the listed bid price.3

Ordinarily, however, in an active market specialists can cross buy and sell orders without their own direct participation. That is, the specialist's own inventory of securities need not be the primary means of order execution. Occasionally, however, the specialist's bid and asked prices will be better than those offered by any other market participant. Therefore, at any point the effective asked price in the market is the lower of either the specialist's asked price or the lowest of the unfilled limit-sell orders. Similarly, the effective bid price is the highest of unfilled limit-buy orders or the specialist's bid. These procedures ensure that the specialist provides liquidity to the market. In practice, specialists participate in approximately one-quarter of trading volume on the NYSE.

By standing ready to trade at quoted bid and asked prices, the specialist is exposed somewhat to exploitation by other traders. Large traders with ready access to late-breaking news will trade with specialists only if the specialists' quoted prices are temporarily out of line with assessments of value based on that information. Specialists who cannot match the information resources of large traders will be at a disadvantage when their quoted prices offer profit opportunities to more informed traders.

You might wonder why specialists do not protect their interests by setting a low bid price and a high asked price. A specialist using that strategy would not suffer losses by maintaining a too-low asked price or a too-high bid price in a period of dramatic movements in the stock price. Specialists who offer a narrow spread between the bid and the asked prices have little leeway for error and must constantly monitor market conditions to avoid offering other investors advantageous terms.

There are two reasons why large bid-asked spreads are not viable options for the specialist. First, one source of the specialist's income is derived from frequent trading at the bid and asked prices, with the spread as the trading profit. A too-large spread would make the specialist's quotes noncompetitive with the limit orders placed by other traders. If the specialist's bid and asked quotes are consistently worse than those of public traders, it will not participate in any trades and will lose the ability to profit from the bid-asked spread. Another reason specialists cannot use large bid-ask spreads to protect their interests is that they are obligated to provide price continuity to the market.

To illustrate the principle of price continuity, suppose that the highest limit-buy order for a stock is $30 while the lower limit-sell order is at $32. When a market buy order comes in, it is matched to the best limit-sell at $32. A market sell order would be matched to the best

3 Actually, the specialist's published price quotes are valid only for a given number of shares. If a buy or sell order is placed for more shares than the quotation size, the specialist has the right to revise the quote.

CHAPTER 3 How Securities Are Traded 79

Table 3.6 Block

Transactions on the New York Stock Exchange

CHAPTER 3 How Securities Are Traded 79

Table 3.6 Block

Transactions on the New York Stock Exchange

Year

Shares (millions)

Percentage of Reported Volume

Average Number of Block Transactions per Day

1965

48

3.1%

9

1970

451

15.4

68

1975

779

16.6

136

1980

3,311

29.2

528

1985

14,222

51.7

2,139

1990

19,682

49.6

3,333

1995

49,737

57.0

7,793

1999

102,293

50.2

16,650

Source: Data from the New York Stock Exchange Fact Book, 1999.

Source: Data from the New York Stock Exchange Fact Book, 1999.

limit-buy at $30. As market buys and sells come to the floor randomly, the stock price would fluctuate between $30 and $32. The exchange would consider this excessive volatility, and the specialist would be expected to step in with bid and/or asked prices between these values to reduce the bid-asked spread to an acceptable level, typically less than $.25.

Specialists earn income both from commissions for acting as brokers for orders and from the spread between the bid and asked prices at which they buy and sell securities. Some believe that specialists' access to their book of limit orders gives them unique knowledge about the probable direction of price movement over short periods of time. For example, suppose the specialist sees that a stock now selling for $45 has limit-buy orders for more than 100,000 shares at prices ranging from $44.50 to $44.75. This latent buying demand provides a cushion of support, because it is unlikely that enough sell pressure could come in during the next few hours to cause the price to drop below $44.50. If there are very few limit-sell orders above $45, some transient buying demand could raise the price substantially. The specialist in such circumstances realizes that a position in the stock offers little downside risk and substantial upside potential. Such immediate access to the trading intentions of other market participants seems to allow a specialist to earn substantial profits on personal transactions. One can easily overestimate such advantages, however, because ever more of the large orders are negotiated "upstairs," that is, as fourth-market deals.

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