Specialists Create Market Efficiency

The NYSE should not abolish specialists. Both the NYSE and NASDAQ, however, need to realize that their relative trading volumes will continue to deteriorate as ECN’s become more and more popular. The need for secondary and third markets will be diminished, however they still offer liquidity, so in some shape or form they will always be fashionable to certain types of investors. The current system established within NYSE is very old and outdated. For any single trade, a number of players must be involved. First, an investor places a buy or sell order to a broker.

The brokerage firm then contacts its commission broker, who is actually on the floor, to consummate the order. In this rigid and time consuming system, the specialist plays a major part in any trade. Any buying or selling in a particular stock takes place at the specialists post. A computer monitor shows all bid and ask prices for a stock in addition to the number of shares they are willing to buy or sell at the given bid ask price. Basically, Specialists execute the trades of other brokers, but they can also buy or sell shares for their own portfolios.

When no other broker can be found to take the other end of a trade, the specialist must take the end of the trade where no one else can be found to do so. This is done to create liquidity, and is one of the biggest benefits to this system. Also, this type of trading creates an auction market, where buyers and sellers are together in one location, and the best buy or sell orders win trades. They also act as a dealer when they have to execute a trade when there isn’t a buyer or seller available using their own inventory. Again, this is meant to facilitate liquidity.

NYSE stocks, until recently, couldn’t trade certain NYSE stocks outside of a formal stock exchange, however the NYSE has since abolished this rule. This has created a small trading volume of NYSE stocks over ECN’s. The current system on NASDAQ and most other OTC’s incorporates dealers, who offer bid and ask prices to brokers who execute trades based on a listing of the current quotes from dealers. Although this is a very liquid market, dealers typically take a spread from the bid/ask price in exchange for the risk that they incur for holding the security.

This is a major downside, because why should any investor be willing to be charged a mark up when they can enter into an ECN where there is no actual spread, other than the capital gain or loss the seller is wishing to capitalize or reduce, respectively. ECN’s are an alternative to both NASDAQ over-the-counter markets and stock exchanges for trading securities. The ECN system allows buy or sell orders to be matched with other buy or sell orders within the system. Both sides benefit because this eliminates any bid/ask spread, which can be very expensive.

Instead, investors are charged a certain fee per transaction or per share, which is almost always smaller than a dealer’s bid/ask spread. Basically, an ECN has eliminated a middleman who takes a profit because it provides an atmosphere of buyers and seller without dealers or a need for a formal trading floor. Additionally, major players on Wall Street such as Charles Schwab, Fidelity Investments, and Donaldson, Lufkin & Jenrette are or have announced joint forms of ECN’s. Most of the big Investment Banks such as Goldman Sachs have invested in ECN’s.

Also, the NYSE is being pressured to incorporate an ECN to trade NASDAQ stocks by the Investment Banks, which as we’ve seen have big stakes at hand because they have invested in many ECN’s. Finally, the advent of ECN’s brings many small investors into play. Although currently small investors don’t have direct access to ECN’s, they can send orders through their brokers who then execute the trade on the ECN. It is widely speculated the future will bring direct access to ECN’s for smaller investors, which is a major reason why so many Investment Banks have invested in this business.

There are, however some drawbacks. This can lead to markets becoming fragmented. Members in one form of ECN have no other form of reference the prices in other ECN’s, or for that matter the prices on NASDAQ or NYSE. In conclusion, there will always be a demand for the NYSE system as we know it and the inclusion of specialists. Each system has it’s own strengths and weaknesses. The NYSE is very rigid and time consuming, however specialists create liquidity. OTC’s create a spread for a buyer and seller in a market, however it is much faster than an exchange and doesn’t require two parties to be on the same floor.

ECN’s virtually eliminate commissions and spreads, but may create fragmented markets. This is precisely why no single system will completely dominate or be eliminated. Market share of trading volumes among the three major markets will trend towards increasing parity. Collectively the three systems as a whole give the market liquidity because certain types of investors may wish to use a certain market. Competition among the markets gives investors more options and creates market efficiency.

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