October 2003
The Profitability of New York Stock Exchange Specialists
On Wednesday, October 8, AEI hosted the second in a series of conferences on the structure of securities markets. This conference focused on the specialist system, in which every NYSE-listed security is assigned to a specialist charged with maintaining a market in the security. This raises the larger issue of outside discipline in determining specialist compensation. Brian Becker of Precision Economics presented a paper on the profitability of the specialists that trade NYSE-listed stock and discussed his work with AEI's Randall S. Kroszner.
Brian Becker
Precision Economics
The New York Stock Exchange is served by seven trading specialist firms that "make markets" for companies whose shares are listed on the exchange. Of the seven, five firms operate within publicly held corporations or are themselves publicly traded. The trading volume of the specialists is similar to that seen across the 250 most active stocks. To offer some comparison, NASDAQ has over four hundred market-making firms. The average NASDAQ stock has over ten competing market makers. As stated by Deutsche Bank, the NYSE and NASDAQ are fundamentally two opposite organizations: the NYSE is a floor-based auction market while the NASDAQ is an electronic dealer-driven market. NASDAQ covers a much smaller market capitalization than the NYSE, and the NYSE uses large capitalization as a requirement to list companies. In this paper, NYSE data was used from public 10-K company filings. In 2002, NYSE specialists earned pre-tax net income of approximately 35-60 percent of their income from the previous year. In comparison, using SIC codes, those classified as security brokers, dealers and flotation companies earned 9.7 percent. Those firms offering investment advice received 14.5 percent. When the NYSE specialists were measured individually, LeBranche & Co. earned 38.4 percent, and Van der Moolen Holding earned 40.5 percent. Measured against their peers, NASDAQ earned 12.5 percent, Knight Trading Group earned 0.5 percent and E*Trade received 8.6 percent. Recent reports suggest that NASDAQ trades more efficiently than the NYSE. NASDAQ's effective spread of 1.5 cents is reported to be 40 percent lower than the NYSE. Similarly, it is reported to execute 81 percent of trades at the quoted price versus only 60 percent at the NYSE. Publicly available information suggests that the specialists derive more revenue per traded share than the corresponding revenue for the NASDAQ market makers. Overall, initial results from the available data indicate that the NYSE trading specialists are very profitable and do exceed their peers and other publicly traded companies. However, further research is warranted and should include evaluating other measures of profitability and examining the profits of privately held trading specialists.
Randall S. Kroszner
AEI
Three issues of interpretation and policy come to mind regarding Mr. Becker's presentation. First in terms of risk, what is the correct benchmark for evaluating whether profits are "excessive?" Second, regarding competition, what are the benefits relative to the costs of increasing the competitiveness of these markets? Third, what is the best governing structure to ensure that interests are appropriately balanced? A one-year snapshot may not capture the riskiness of the income stream. Additional risk factors include volatility of stocks, market movements, and extreme events such as September 11th.
The role of specialists is to maintain a fair, competitive, orderly, and efficient market. They act as auctioneers, agents, and principals. As a result, the risk and burdens of specialists differ with those of others. Specialists are required to "use their capital to bridge temporary gaps in supply and demand and help reduce price volatility by cushioning price movement," according the NYSE. One can evaluate such a practice by comparing the amount of support specialists provided in the crash of 1987 and September 11th to the support provided by competitive market makers from NASDAQ during those same events. Competition as a policy issue raises questions of tradeoffs between a centralized market with higher liquidity and a competitive market that may be more fragmented. Does a traditional "monopoly" specialist work better in times of extreme market stress? Becker's data seems to suggest that liquidity and specialist competition are lower among NYSE market-makers than those the market-makers at NASDAQ. To enhance competition, the NYSE must allow for multiple market makers at NASDAQ and reduce the burdens of the "trade-through rule" directing trades to the floor. The key is to achieve maximal competition while maintaining a liquid and orderly market.
This summary was prepared by AEI Staff Assistant Jessica Browning.
