The Specialist as a member of a stock exchange has two functions.’ He must execute orders which other members of an exchange may leave with him when the current market price is away from the price of the orders. By executing these orders on behalf of the other exchange members when the market price reaches the price stated on these orders, the specialist makes it possible for these members to perform their business elsewhere on the Floor. In handling these orders, the specialist acts as broker or agent. In addition to the brokerage functions, however, he has historically had the additional function of acting as dealer or principal for his own account. Under current rules and regulations of the exchanges and the Securities and Exchange Commission, purchases and sales for his own account must be made, insofar as reasonably practicable, with a view to assuring a fair and orderly market in the stocks which he services. Moreover, whenever there are public buyers but no public sellers, or public sellers but no public buyers, he is expected, within reasonable limits, to buy or sell for his own account in order to decrease price differences between transactions and to add depth to the market. He performs both functions for a limited number of issues assigned to him by the stock exchange.
In 1935 the Twentieth Century Fund’s study of the securities market concluded that: Specialists, as well as other exchange members, should be permitted to function either as traders or as brokers, but not as both. . . .No specialist, or other broker, should be permitted to have any interest in any trading account, pool, syndicate, underwriting operation or option!
The Fund’s basis for this conclusion was its belief that “the services rendered by the specialist are not of sufficient value to warrant the continuation of a condition where a small group of persons is given a preferred position in the market.”
One year later the Securities and Exchange Commission in studying the same system reached the conclusion that insufficient data had been presented to justify the segregation of functions.’ In 1941 Professor Vernon, then a member of the Commission staff, suggested an alternative to considering the specialist in terms of his general beneficial or detrimental effect on the market as both the Twentieth Century Fund and Segregation Report had done. He stated that the feasibility of regulating the specialist should be viewed in terms giving recognition to the possibility that his job may vary in different types of stocks . . . .The dealer role of specialists may be necessary and justifiable for one set of stocks, providing sufficient grounds for overlooking his advantage over the public as a dealer in such issues, while his dealer position in another group of stocks runs contrary to the public interest In actively traded issues where a sufficient number of buyers and sellers exists to assure a continuous market with each sale price related to the prior sale, Vernon reasoned, little justification for the specialist function exists. He recognized the need for greater study to effectively develop such segmented rules regulating the specialist’s activity.
Little was written on the specialist system in the exhaustive manner of the Twentieth Century Fund, the Segregation Report, and Vernon’s book until 1963 when the Commission’s Special Study reported that “in its present form, [the specialist system] appears to be an essential mechanism for maintaining continuous auction markets and, in broad terms, appears to be serving its purposes satisfactorily.”‘ With the adoption of rule 1 lb-110 which recognized both the dealer and broker functions of the specialist, the issue seemed finally settled, at least from a legal standpoint, that the specialist system’s beneficial effects surpassed any defects.
ECONOMIC ROLE OF THE SPECIALIST
Several important questions should be examined to acquire an understanding of the economic motivations -present in the specialist system and of the impact of the specialist on market prices. To what extent is the specialist’s monopolistic, or oligopolistic power to administer the price of his specialty stock limited by his obligation to maintain a fair and orderly market? Can a specialist be a speculator and still meet this obligation? What do the terms “fair market” and “orderly market” mean?
In any economic categorization of the specialist’s function, the specialist’s position as the price administrator of his specialty stock requires analysis. To the extent that he is a sole” price administrator, he may be considered a monopolist Professor Baumol comments that “the specialist must be treated not as a competitor, but, on the contrary (at least for a narrow ‘normal’ price range) as a price administering monopolist or oligopolist.”‘ In part his conclusion depends on the assertion that the specialist knows the demand and supply curves through his “book” and can “choose to end up at the spot which is most favorable to him from among all the points that constitute the market’s offer curve.”‘
Any economic analysis of the specialist’s role must also consider the obligations of the specialist both under the securities laws and the applicable rules of the stock exchanges. While economic theory is practically limited by the specialist’s legal obligation, that theory should be influential in interpreting or formulating particular rules within the legal framework. Since obligations may differ as the time period is lengthened, the specialist’s economic role can be classified into three time periods: short, intermediate, and long run. The unique nature of the specialist’s function suggests a fourth classification-sudden price fluctuations.
While the latter category generally occurs within the short run, it warrants special attention because it involves unique legal and economic considerations.
The primary emphasis on the role of the specialist has always been on his short run” value to the market.6 He is obligated to reduce temporary disparities between supply and demand in order to facilitate a fair and orderly market. However, the meaning of “temporary disparities” is unclear, since the time duration of the specialist’s short run obligation may depend upon the particular facts of the situation. Arguably, in certain instances, his obligation may be for only a few hours or less if his economic capability as a dealer is threatened by a deluge of orders. Thus the specialist’s obligation to maintain a fair and orderly market is limited in the sense that no one expects him to go bankrupt performing his daily duties. His monopolist’s or oligopolist’s role is further limited since the direction in which he is obligated to administer the price of his specialty stock is against the market trend.
To evaluate the specialist’s performance the NYSE uses the “tick test” to determine if he is acting to maintain a fair and orderly market. By this test, specialist purchases below and sales above the last different price are deemed stablizing and therefore proper.”
The specialist has a certain amount of discretion in exercising his short run obligation. In some situations, he has no choice but to enter the market as dealer and consequently is obliged to be a price administrator.
Other situations, however, do not necessarily require his entry into the market nor do they foreclose his participation. For example, if the highest bid on the “book” is for 100 shares at 20 and the lowest public offer is at 20 3/8, the specialist might in certain cases have discretion to either place his own bid or withhold himself from the market. If the situation were changed so that the lowest offer was at 24, making the spread four points, the specialist would be obliged to enter the market as dealer. In this instance he would be required to administer the price of the stock. But depending on numerous considerations including the last sale price of the stock, competition from both regional stock exchanges and the third market, and volatility of the stock, he has a certain amount of discretion in determining how to enter the market-as a bidder, offeror, or both-and at what price. Hence, even when he is under an obligation to administer the price of the stock, the manner in which he exercises this obligation is somewhat discretionary so long as his action ultimately promotes a fair and orderly market.
It should be noted that while many monopolists and oligopolists are regulated as to the price they may charge, the specialist, because of the very nature of the “free market'” could not be so regulated.
In considering the specialist’s short run value to the market, a problem arises in determining when “temporary disparities between supply and demand” cease to be temporary. The answer arguably appears after the situation has occurred, making the short run obligation as nebulous as the actions of market prices themselves.
Sudden Price Changes
The possibility of sudden large shifts in market prices provides a major justification for the specialist’s existence.
The shift may result on an individual stock-by-stock basis due to a public announcement by management or from a sudden rise or decline in the general market. While suspension of trading in the specialist’s stock or in all stocks will release the specialist from his obligation, 9 a considerable economic dislocation will undoubtedly occur between the influx of orders and the eventual suspension of trading. In the interim the specialist is expected to add depth and liquidity to a market which would otherwise be devoid of these characteristics. In two previous sharp declines specialists have been net purchasers, but their participation probably depended not only upon their obligation but upon their economic outlook. Although specialists were net buyers immediately after President Eisenhower’s heart attack and during the sharp market decline of May 28, 1962, their stabilization effect on these two occasions differed greatly.
According to the Special Study, one reason for the lack of substantial purchases by the specialists on May 28 was their belief that this decline was non-temporary in nature!’ The stabilizing effect of the specialists on May 28 was widely publicized by the NYSE, implying that at least the Exchange felt that most specialists had met their obligations n The emphasis placed on net purchases by both the NYSE and the Special Study indicates that the characterization of the specialist as a stabilizing monopolist or oligopolist definitely includes the daily periods of sudden price movement. The extent to which the specialist must meet this obligation is difficult to determine; numerous factors including his capital status must be considered. The Special Study commented; “Obviously, no one person has the capital to stem a selling wave such as that of May 28, but with his central location, the specialist is in a position to cushion the public’s selling by giving depth to the markets.
The Intermediate and Long Run
The specialist’s obligation to stabilize the market is reduced as the long run is approached. Indeed, if such an obligation exists in the long run, the auction market would be a manipulated, rather than a free, market. The terms used to describe the specialist’s function-“fair and orderly market;” “temporary disparities between supply and demand;” “liquidity and continuity,—as well as the “tick test” and the limited capital requirement of the specialist place emphasis on the specialist’s economic role over the short run.
Regardless of the duration of the specialist’s obligation, economic .analysis of the specialist’s role must necessarily consider Congress’ two basic aims that the stock market be “fair” and “orderly.”‘
Professor Vernon commented:
- A “fair” market . . . bears the connotation of a market in ,which the individual investor need not fear for the integrity of his broker, the safety of his funds, or the possibility that price movements are being artificially controlled.
- An “orderly” market is regarded as one in which there are no “sudden and unreasonable fluctuations in the prices of securities” and consequently a market which makes no unnecessary adverse contribution to the stability and well-being of the public at large. The two major functions of regulation, therefore, are carefully distinguished; the goal of fairness, directed primarily at the protection of the individual, may be looked upon as something in the nature of a police function, while the “orderly market” aim, an aim intended to benefit the general public interest, is more suggestive of the use by Government of economic controls.
Clearly, [orderly market] was intended in some way to represent a market which was free from “excessive speculation,” a type of speculation which, we are told, results “in sudden and unreasonable fluctuations in the prices of securities.”
No agreement exists concerning the effect of speculation on stock prices. Under one theory, the speculator stabilizes prices by purchasing or selling as necessary to move prices toward an equilibrium position. A contrary theory assumes that the speculator will continue to follow trends past the equilibrium. Under the latter hypothesis the mere presence of traders in the market can accentuate, rather than dampen, fluctuations.2 Thus generalities are not possible.
Not all speculators follow, or in the case of specialists, should be permitted to follow, a destabilizing pattern. The “bad” speculator aggravates price trends by going with the trend; the “good” speculator goes against the trend, thereby adding stability to the market. The “bad” speculator may have prompted Congress’ adoption of the “orderly market” standard. To the extent that the specialist is not permitted to buy or sell except to promote a fair and orderly market, he is prevented, at least on a trade-by-trade basis, from being a “bad” speculator. Thus, the scope of his obligation under the applicable rules of his exchange and the obligation imposed by the 1934 Act and Commission rules thereunder are of importance in limiting instability due to speculation?
Some economists, including Professor Stigler, believe that the specialist’s ability to “predict changes in equilibrium prices, or, in other words, how closely does he keep bid and ask prices to the levels which in retrospect were correct” should be a criterion for judging his efficiency. To the extent specialists are able to estimate the future course of events they would “smooth the path of the price quotations. Hence, the specialist’s own profit motive as a speculator, rather than any imposed obligation, would enable him to perform his economic and legal roles. Stigler further criticized the suspension of trading in a stock in an emergency situation, believing that the mechanics of speculation would work as effectively here as in a normal market.
Some disagreed with Stigler’s approach. Considering the proposed standard of market efficiency-the success of the speculator in judging changes in equilibrium prices-commentators argued that Stigler implicitly assumes that speculators do not affect equilibrium price, so that the existence of speculative profits is necessarily a reflection of the success of speculators in anticipating movements in equilibrium price . . . .This is a basic assumption . . . without justification . . . .There are both theoretical and empirical grounds for believing that the demand schedule of investors in the stock market is greatly influenced by price movements, so that speculators can profit substantially by trading actively which is destabilizing. For example, if speculators make heavy net purchases of a security in a period when its equilibrium price has risen moderately as a result of favorable financial news, their activity may drive the price much higher than it would otherwise have gone 3
Replying to this criticism, Stigler stated that he did consider the effect of the speculator’s activity by assuming “that the speculator’s balances are equal at the beginning and at the end of a speculative interval.”” The rebuttal to Stigler’s reply concluded that Stigler’s economic model “assumes that the equilibrium price of investors is not affected by price movements or by the speculator’s effects on such liquidity of the auction market in which specialists play a pivotal role. In this connection, they are considering an increased role for block positioning firms with specialists. In that case, the specialist rules which evolved to fit the needs of individuals may have to undergo profound changes to satisfy the new situation and the increasing role
of block positioners. Even if the exchanges succeed in their efforts to bring and keep blocks on the floor of the exchange, the changes in structure due to the growth of blocks may result in the growth of a situation which many feel currently exists-that is, two de facto separate markets, a negotiated market for blocks and the traditional specialist auction market for individuals.movements,” notwithstanding Stigler’s contrary assertion. Reference was again made to the substantial evidence indicating that the speculator could indeed aggravate price movements and thereby be destabilizing.
Reprint of The Stock Exchange Specialist: An Economic and Legal Analysis, by Nicholas Wolfson and Thomas A. Russo
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