Wall Street debates: Is the specialist system outdated?
Boston — For stock exchange specialists, ``Black Monday'' and ``Terrible Tuesday'' sorely tested them, and they lived through it. ``The specialists in the auction market survived handily,'' says Kenneth Leibler, American Stock Exchange president.
Specialists, the members of stock exchanges charged with keeping order in the markets of the stocks they buy and sell, have received their share of scrutiny as people try to understand what happened Oct. 19, when the Dow Jones industrial average fell 508 points, and Oct. 20, when the exchanges were said to be within an hour of breaking down.
``The most important thing was to keep the doors open, or else we wouldn't have reopened,'' says Louis Miceli, a partner in Miceli-Van Caneghan & Co., on the American Stock Exchange. He has been a specialist since 1960.
``The key is that the specialist can be beat up, lose money, be exhausted, but the system will work. Maybe the markets weren't as good as they had been, but there were markets,'' he adds.
On Black Monday, specialists were swamped with sell orders, and they had to step in and buy stocks when no other buyers came forth. Tuesday such big-name stocks as DuPont, Merck, IBM, and Eastman Kodak stopped trading. Without buy orders, the specialists could not make markets. ``Maybe 50 out of the 1,500 stocks stopped trading,'' estimates Robert Fagenson, whose specialist firm handles 62 stocks on the NYSE.
The specialist's job is to match buyers and sellers. As such they are dealers, auctioneers, cushions, and traffic cops. ``Seventy-eight percent of the time the buyer meets the seller; the other 22 percent, the specialist is there,'' explains NYSE floor broker David Shields. They are expected to buy or sell stocks in their own account to offset temporary imbalances in supply and demand and thus prevent wide swings in stock prices. They must meet strict capital requirements set by the exchanges.
In the aftermath of the market's plunge, some have suggested that the specialist system is inadequately capitalized and partly to blame. Others have suggested that the specialist system is outdated.
Specialist firms lost up to two-thirds of their $3 billion in total capital on Black Monday. Specialist purchases were important, and Wall Street Journal reporters James B. Stewart and Daniel Hertzberg concluded that specialists could not meet the demands. In their month-after-the-collapse story Nov. 20, they wrote, ``And the crisis in the financial system revealed glaring weaknesses that are being closely examined in Congress. The New York Stock Exchange specialist system - despite some heroic efforts - proved inadequate to meet the demands of huge international flows of capital, nearly triggering a shutdown of the exchange and a public crisis of confidence....''
Mr. Fagenson, however, does not think capital requirements need to be changed. ``It was adequate to handle the responsibility,'' he says. ``The answer isn't more capital. More capital would have meant the institutions would have sold more, and losses would have been larger. The problem wasn't the loss of specialist capital - it was the absence of real buying.''
Given the pace of technology, some people say that investors would be better served with computers than with specialists. ``Specialists are outdated,'' claims Morris Mendelson, a professor of finance at the Wharton School of the University of Pennsylvania.
``They simply failed. They don't have enough money to deal with the institutional market. If investors could have accessed the market through a computer, it would make a more efficient market,'' he says.
In 1975 Professor Mendelson and two others proposed that the markets be computerized, so that ``a public order could meet a public order. If the order is too low, you can hold the order until there's a buyer. It's inevitable,'' he says.
Specialists are not eager to disclose their personal losses. ``We still have a lot of capital, and we bought a lot of stock when the market fell; we lost a lot of money, but we lived to trade another day,'' says Michael Creem of Mercator Partners, a specialist firm on the NYSE that handles the stocks of 60 companies.
The market's plunge has accelerated the trend toward consolidation of specialists. Two NYSE specialist firms and one on the American Stock Exchange have been bought out since Oct. 19. About 20 years ago, the NYSE had 150 specialist firms; today it has 52, says Mr. Creem, who has been a specialist since 1956.
In 1986, the Securities and Exchange Commission approved a rule allowing brokerages to own specialist units, provided they establish a ``Chinese wall'' to separate a firm's investment banking and research from specialists.
Mr. Mendelson thinks a proposal from the National Association of Securities Dealers, which runs the over-the-counter stock market, would provide a better system for customers in that market. Following the market's plunge, charges were leveled that some OTC traders did not answer their phones.
OTC marketmakers can enter and leave the market through their computerized system whenever they wish. Specialists are supposed to make a market if no other buyer or seller is available.
The NASD has proposed four changes, emphasizing an increased use of computers in making markets; people making markets over the phones would also be required to stay within the automated trading system even when markets go against them.
But Mr. Shields, who has been an NYSE member for 21 years, says computers will not replace specialists: ``Until we have artificial intelligence that can obviate the need for people, there will be people.''