In defence of the specialist market makers with a human face..
Friday, October 3rd, 2008
Did Wall Street’s “Specialists” Save Us from a 1,300-Point Decline on Monday?
By Martin Hutchinson
- The 777.68-point nosedive in the Dow Jones Industrial Averageon Monday was the single-biggest point drop ever, eradicating $1.2 trillion in shareholder wealth, and leaving mainstream investors feeling shell-shocked after the House of Representatives rejected a $700 billion banking bailout bill.
- But here’s what most people don’t know. The damage could’ve been much worse.
- In fact, without a little-known group of traders, known as “specialists,” Monday’s wrenching drop could have extended into a 1,500-point freefall. Without these specialists, Americans could’ve easily watched as half their retirement savings was vaporized during the day’s seven-hour trading session. So, here are these market-miracle-makers. Should we be thankful for them?
- The Reports of Our Demise …
- Some readers may be surprised that human NYSE specialists still exist, so accustomed have we become to the propaganda about the superior capabilities of machines. Indeed, only last year, the news media was crafting the epitaph of the floor trader: The open-outcry system – which once featured frenzied traders screaming “Buy” and “Sell” – was replaced by computer-trading specialists, and the floor itself was less frenetic after job reductions had reduced the number of traders from 3,000 to 2,100 over the course of just a couple of months. It had been a world of paper-strewn floors, lights, scoreboards, hand-signals, uniforms and even referees.
- At the same time, however, techno-skeptics like me may well ask the ultimate heretical question: Do human beings trade better than machines?
- A Postmortem on the “New” Black Monday
- Proponents of the open-outcry trading say that specialist market makers on the NYSE – faced with a rush of “Sell” orders late Monday, either took the buy side or aggressively solicited for buyers of shares of several of the big financial-services companies that were part of the sell-off.
- By assuming the role of buyers – or soliciting buyers – these specialists may have helped limit losses at the closing bell, the Dow Jones news service reported. Specialists that represent some of these financial companies said they would take “Buy” orders in a late crossing session – a move that helped put a floor under some of the selling, and probably staved off an even bigger decline, Dow Jones said.
- “If this was purely electronic, it could have been down 1,200 or 1,300 [points] on the Dow,” Bernie McSherry, a senior vice president with Cuttone & Co., the largest independent floor operator at the NYSE, told the news service.
- Man vs. Machine
- When it comes to executing a dentist’s 500-share order in a liquid stock in an “ordinary” market, there’s no question that machines (computers) do the job in a perfectly adequate manner. They compare the prices available in the market, select that which is most advantageous to the dentist, and execute the trade, all in less than a second, limiting the dentist’s risk of price movements after the order has been placed. What’s more, they do this far more cheaply than a human trader, since they can – if necessary – execute thousands of orders at once.
- In the 1920s, the Big Board frequently had to shut for some weekdays, so that the back-office staff could get caught up on the unprecedented volume of trading. Needless to say, that is no longer necessary: the very same machines that execute the trades handle all the details of order matching and payment.
- That has been the rationale for forcing human traders out of the market, closing trading floors and using computers to “make markets.” The NASDAQ uses computers entirely, as do several automated trading platforms such as the NYSE’s Archipelago. London gave up its trading floor as long ago as 1987, after misguided legislation forced all the trading firms into conglomerate ownership and led experienced traders to retire with their (in those days) modest winnings.
- NYSE specialists have seen their market share gradually eroded, as the big institutions push for automation, and the general view a year ago was that they were due to go the way of the Dodo, and that the NYSE was being stubborn and foolishly limiting its competitiveness by continuing to allow them to operate.
- That was always an implausible theory. Studies have shown that only 7% of the information in a conversation comes from the words themselves: Another 38% is gleaned from the tone of voice used, while a full 55% is derived from non-verbal clues. For maximum communication, therefore, humans need to be face-to-face – not at opposite ends of a telephone, or rattling away on a computer keyboard. Skilled and experienced traders have always been able to tell the tone of a market by listening to it and observing the behavior of its participants. It therefore follows that in markets where uncertainty is high and the need for information great, face-to-face trading is the optimal way of conveying information to other market participants and of gathering information about the market mood and likely direction.
- As traders, computers have another disadvantage: They have no “common sense.” Back in October 1987, a newly discovered form of “program trading” known as “portfolio insurance” helped cause the Dow index to drop 22% in a single day, costing investors an estimated $500 billion at a time when there was little or no underlying economic reason for such a fall. On that “Black Monday,” the computers kept selling in order to hedge themselves and by doing so made the situation infinitely worse. The NYSE has instituted “circuit breaker” rules that close the market on extreme moves to guard against the possibility of some damned machine bankrupting everybody, but in a truly extreme situation the only real solution may be a power cut.
- The Specialist Saviors
- In a market meltdown, such as occurred Monday afternoon, specialists are vital. Of the 1.8 billion shares that traded that day, specialists accounted for 141.5 million, more than double their average daily trading volume of 63.5 million for 2008. Needless to say, by buying the most knocked-down shares at the cheapest prices, the specialists were able to reap handsome rewards Tuesday morning, when the market recovered. However, they also performed a vital market stabilizing function.
- Of all the NYSE specialists, the New York-based LaBranche & Co. Inc. (LAB) is the only one that is still publicly quoted in the United States (Van der Moolen Holdings NV trades on the Amsterdam exchange). During the past year, LaBranche has run losses; its trailing 12-month earnings figure is actually a loss of 61 cents per share. However, the company is expected to turn a profit in the second half of 2008 and its market capitalization is only $300 million – the equivalent of 67% of 2007 revenue – so if the NYSE specialists make a comeback, there’s plenty of upside to go for.
- Perhaps it’s worth a small flutter.