NYSE: What Are They Hiding?

May, 2003

The New York Stock Exchange (NYSE) is not investigating “front running” by specialists but rather this is a case of “negative obligation.”

Is this merely obfuscation or is there a difference? In the case of front running, the specialist uses inside information about an order to buy or sell ahead of that order, insuring a risk free profit by re-selling immediately afterwards. In “negative obligation,” the specialist uses inside information about public orders to buy and sell and “unduly intervenes” to make a risk free profit (or at least to position his book advantageously). In both instances, the naïve investor rarely realizes that their trust has been misplaced. Huh?

Is this another case of a self-serving financial institution trivializing matters so that they may continue to fleece the public trust? Whether it is such a blatant attempt or not, the sorry situation focuses attention not just on the role of floor specialists, but on the very problems inherent in the NYSE’s system, specifically as it relates to a monopoly-which the specialist system is — having quasi-judicial and self-regulatory powers.

The specialists and the NYSE are a self-regulating monopoly? As difficult as that may be to fathom, the answer is yes. One stock, one specialist and they police themselves. Sounds as if the foxes guarding the roost have been handed a set of sterling silverware in which to dine on all those innocent hens. Hardly the description of a free-market system, less so the institution — the NYSE — held out as the core of capitalist America. And therein lies the rub. Does anyone actually think that the NYSE has now, or ever has had, an interest in going beyond the incident they happen to be investigating to pursue a pattern of violation–whether it be front running, failure to post proper inside spreads, manipulation of stop-loss orders, negative obligation, or any of the other practices that provide specialists an advantage over the individual investor? In other words, do the NYSE enforcers ever use prosecutorial-like leverage to dig deeply into the system to get at a large-scale pattern of deception? On a case by case basis, they have leveled token fines of $10,000 to $250,000 (and only the large amounts recently) and by and large allowed specialists to plead no contest and to go on with their lives–end of discussion. Were it not for the media picking up this most recent story, does anyone actually believe this time would have been any different?

An outside prosecutor — say someone with the zeal and ambition of New York Attorney General Elliot Spitzer — armed with appropriate remedies, would squeeze an individual under investigation and negotiate for information about other violations. There are few market insiders who doubt that David Finnerty, the specialist most recently fined and suspended, could blow the top off of the Exchange’s long history of self-serving practices.

And what are “appropriate remedies?” If someone subject to normal regulatory scrutiny were to conduct illegal activities that netted potentially millions of dollars in illicit gains at another’s expense, that person might expect to face serious criminal prosecution, including the possibility of significant jail time. Faced with that, such an individual would feel the pressure to cooperate with authorities.

In a self-regulated environment, however, especially one in which it is possible many of those in charge of regulation may be similarly guilty at some point in time of these same types of violations, and where the very existence of the enterprise is in jeopardy, one would expect the system to work in just the opposite direction-namely, that anyone blowing the whistle would be more heavily penalized, not less so. “Take your lumps, shut up, and you’ll be okay in the long run.”

Let’s look at yet another but related aspect of this NYSE beast. Because the Exchange is quasi-judicial, it has teeth to sink into any member firm that might want to step forward and point a finger at fellow NYSE member. That willingness is further tempered by the fact that so many of the specialist firms are owned by investment banks. That only compounds the anxiety and risks for potential nay-sayers and whistle-blowers.

Finally, an element missed by everyone so far is the admission by Finnerty (via boasts attributed to him) that he has had a cozy relationship with the top managers of traded companies. How prevalent is that among specialists? “Very” is the likely answer.

Many company managers are naive about the process of trading and believe the specialist is their ally — someone whose well-being must be protected in order to protect the smooth trading of their companies’ shares. Information sharing? Certainly it raises questions.

Even if all of this is unfounded speculation, isn’t it about time that the NYSE, an entity that is monopolistic, self-regulatory, quasi-judicial, may use capital to trade with, and acts as agent (charging commissions for orders left on specialist books) opened itself to scrutiny? If, as Dick Grasso argues, there is nothing to hide, then let’s put all doubts to rest by insisting on outside prosecution and opening up the specialists’ books. Let’s check the specialists’ positions ahead of the announcement of material, nonpublic information (i.e., gap openings, for example). Let’s look for fact patterns to see if their positions are as random as they should be at the time of such announcements. A logical person might believe that if there are specialists under investigation for “negative obligation” then at least a few of those folks might have “front run” a time or two. A thorough, unbiased audit ought to resolve these matters once and for all.

In their recent release of April 22, the NYSE said that no firm has failed an “examination.” No firm, they continue, had failed an audit, nor does the NYSE conduct audits. That make sense: nobody is likely to fail an audit not conducted. See no evil, speak no evil. All the more reason, I say, to grab this potentially rotten apple tree and shake it until it either breaks or gets healthy.