Specialists, How They Use Their Merchandising Strategies By Richard Ney

Specialists, How They Use Their Merchandising Strategies And Self-Regulation For The Manipulation Of The Stock Market People who invest in the stock market usually don’t spend too much time thinking about the specialist, why he is important, and why he should be very carefully supervised and regulated, until such time as there is an awesome crash in the market. At such times the public hollers for an investigation of the stock market. Since most of those in government doing the investigating are beholding to the Stock Exchange in one way or another (via campaign contributions or through their law firms), or hope (if they are commissioners and chairman of the SEC) to be employed in the securities industry at some not to distant date, nothing ever comes of these investigations. Those in government charged with the administration of the securities industry and who conduct these investigations are fully aware that since the turn of the century the findings of such investigations have centered on the fact that the deep and inexorable cries of the stock market are caused by the failure of specialists to operate the market in a fair and orderly manner when acting as dealers for themselves while in direct competition with the investing public. According to the “Report of the Special Study of Securities Markets and Exchange Commission” of 1963: Specialists are at the heart of the problem of organization, management and disciplinary procedures of the exchange…. the misuse of their role in the operation of a fair, orderly auction market and the breakdown of regulatory and disciplinary controls over them… are part of a complex pattern of interlocking causes and effects. It is for this reason that any program or reform must concentrate heavily on the dominant role of the specialist.

In the past even the most public-spirited investigation of the specialist system, which was the 1963 Report, declined to acknowledge the exact manner in which specialists employed their merchandising

strategies to maximize profits for themselves at the expense of individual investors. Part of the reason is that specialists are not bound by either the rules of the Exchange or the SEC to inform the public or anyone else about the specifics of all of their transactions. The SEC’s report did, however, pointedly insist that the specialists’ conduct did not conform to the established code. Where their most important practices were concerned, specialists employed techniques, which were impossible for the public to follow because of the specialists’ unwillingness to provide the public with information concerning the details of their activities. In particular, it singled out the specialists’ use of the short sale. Under ordinary circumstances, an individual buys stock in anticipation of a subsequent rise in price, which will enable him to sell it at a profit. When an investor sells short, he reverses the process by first selling the stock in anticipation of a subsequent “decline” in price which will allow him to then buy the stock back at a lower price. His profit (or loss) is the difference between the price at which he first sells the stock and the price at which he later purchases it. When an investor wishes to sell short, (IE) to sell stock he does not yet own, his brokerage firm will normally arrange to “borrow” the stock from their or another brokerage firms pool of securities, with the understanding that at a later date the investor will return those share. This investor is then able to make delivery with his borrowed stock to the party to whom his broker sold it. When the investor later makes his “covering” purchase of the stock, he is then able to return the shares he borrowed to clear his obligation. The act of selling stock, which an individual does not own, is called “short selling,” while

his subsequent purchases are referred to as “short covering.” When a specialist uses the short sale, the process is basically the same. There is, however, one very important difference. When an investor sells a stock short, he “thinks” that the price of the stock will decline, whereas the specialist’s short sale is based on the certainty that he intends on taking the price of the stock lower. The power of the short sale can be seen in the manner in which the instrument allows specialists to completely control the forces of supply and demand so that ultimately they can raise and lower prices at will. In the hands of the specialist the short sale is a triumph of human ingenuity. Thanks to the nature of the instrument and its paradoxical functions, the short sale enables specialists to determine the short, intermediate, and longterm price objectives of their stocks. As an example of how short sale rules have been distorted for the benefit of insiders with the aid of the SEC is as follows: In 1938 the Commission enacted a short-selling rule that prohibited Stock Exchange members from “demoralizing the market” by effecting short sales at or below a price lower than the last sale. This rule was meant to prevent “short sellers from accelerating a decline by exhausting all remaining bids, offers to buy, at one price level, causing successively lower price levels to be established.” The SEC however, provides specialists with a loophole that allows them to “demoralize the market by selling short on downticks” (without having to report these transactions as short sales) whereas the investing public can only short on upticks. (A transaction that is executed on an uptick occurs at a higher price than the last preceding price, while a transaction that is executed on a downtick occurs at a lower price than the last preceding price.) Indeed, investors have remained

totally unaware of the myriad controls over individual stock prices and the market as a whole accruing to specialists through their use of the short sale. To those that think that my statement that the specialist is able to manipulate stock prices at will seems far fetched, the SEC’s Special Study Report provides an illustration that documents this conclusion. Quoting Bill Meehan when he was the specialist in Ford, the Report provides you with an insiders view into the process in which specialists are able virtually to guarantee a profit for themselves in the course of a long bear market. Meehan shows you that he was able to do this by selling short and then lowering his stock’s price levels at which he then “covered” his short sales: Not that I am a student of the charts, but I took a look at the Ford chart and it looked very dangerous to me. I liquidated our whole position and went short and we maintained a short position, actually in only three of our stocks, all the way through, practically, during the whole period. During the day, we would become long, but almost every night we were short stock. [SSR, Part2, Page 113]

In order to understand the implications of what Meehan is saying, it is important to understand that when specialists rally stock prices, public buying is attracted. Conversely, when specialists drop the prices of their stocks, the public on balance can be expected to sell stock. Thus Meehan, in the course of dropping the price of his stock in the market crash of 1962, accumulated an inventory of stock in the morning, (in all probability most often at or near the opening) from investors who frightened by the decline that was taking place in the stock and fearful of a further decline, had entered their sell orders to sell. Thereafter, he was able to reduce his inventory by rallying stock prices. The rally would attract public buying demand in sufficient quantities to enable him not only to liquidate his trading account “during the day”

but to also “short stock” almost every afternoon. As you can see, his short sales were indispensable in taking down the stock prices profitably in a bear market, in this case in what was one of the worst bear markets encountered by investors in the 20th century. Equally important to recognize is that this example documents the manner in which the short sale enables specialists to manipulate their stock prices up and down at will regardless of whether the market is a bull or bear.

then to take stock prices down to wholesale price levels in order to cover his short sales and once again accumulate stock. The establishment of these accounts is, of course, the signal for the noticeable shift in the specialist’s posture toward his stock’s price trend. Once he accumulates or distributes his stock from his investment accounts, the manner and intent of his activities will be biased toward advancing or lowering his stock’s price in order to maximize his personal profits.

A business week article stated, “If specialists apparent monopoly looks like a license to steel, the specialists have an answer.” “If we make so much money,” they argue, “why isn’t everyone else trying to get into our business?” When outsiders do investigate the possibility of this, they discover that it would probably be easier to break into Fort Knox’s.

Another feature of the investment account involves the manner in which the specialist links it with his trading account for both distribution and tax planning purposes. The tax advantage the investment account offers is that it enables specialists to declare as long term capital gains what are legitimately short term capital gains. If for example he acquires a position in his investment account at his stock’s lows and advances his stock’s price to its high in less than a 12-month capital gains window, he can employ his investment account to turn what would otherwise be short term gains into long term gains.

Each of the specialist’s privileges has a decisive influence on the destinies of investors; some offer him more opportunities for profit than others. Unknown to most investors, in addition to the profits from their trading accounts, specialists have what are called “long-term segregated investment accounts.” The SEC’s Institutional Investor Study has calculated that specialists make between 84 to 192 percent a year on their capital. The article stated, however, that the study had “ignored specialist investment accounts.” The fact is that although the SEC has from time to time mentioned specialists’ returns from their trading accounts, it has always consistently refused to provide any information concerning profits from a specialist’s business or his investment accounts. Observation of specialist’s activities reveals that once he has sold out his investment account and established a short position at the stock’s high, his long-term objective is

To do this he would liquidate whatever stock he has in his trading account at the high and then establish a major short position in the account. Then all he needs to do is wait until the 12-month capital gains period passes to qualify the accumulations in his investment account for long term capital gains and deliver over those shares from the investment account in order to cover the short positions in his trading account. In this manner he can legally call his profits “long-term.” It was interesting for me to learn that this information is of little or no concern to most investors. In fact, the comments of many are “so what? Everyone wants to save on taxes. Why shouldn’t he be able to just like everyone else?” What most investors have failed to grasp was that the issues involved were far more important than whether or not specialists are allowed to enjoy the tax

benefits of turning short-term gains into longterm gains. The issue in fact, is whether or not tens of millions of investors should be subjected to rhythmic market booms and busts so that specialists can establish their capital gains. It is also worth observing that if the matter were not of such an obvious and pressing nature, the specialist study group would not have so well presented the dark side of the issue (Special Study Report, Part 2, page 133): Purchases made on the Exchange for the purpose of segregation into long-term investment accounts raise problems, which go to the heart of the specialist system. The specialist is permitted to trade for his own account only when such trades affirmatively contribute to the maintenance of a fair and orderly market. Where the specialist goes into the market with the intention of segregating the securities purchased and not with the purpose of creating a fair and orderly market, the trading is clearly contrary to the statutory and regulatory standards. Beyond this, the specialist with a longterm position now has a stake in seeing the securities rise in price - he has become an investor as well as a dealer. A further problem arises when the specialist who maintains such long-term accounts is required to sell stock to maintain a fair and orderly market and he has no stock in his specialist trading account. [If] the 12-month period of the tax statute is almost over, the specialist may well be tempted to keep his stock in the long-term account and neglect the needs of the market.

In reply, the NYSE maintained that specialists have a perfect right, like anyone else, to accumulate stocks as investors and stated “it believes that it is perfectly proper for the specialist unit to carry stock in a long-term investment account.” It terminated any further discussions with the SEC on this matter with the following statement that “further discussions of this question between the Exchange and the SEC have been deferred.” This is the true meaning of self-regulation. It has been argued that great changes have been mad since the Special Study Report of 1963. However, Arnold I Milsky, who was a

NYSE specialist for nine years and was the head of his own consulting firm, offers some insight into this opinion: The Big Board is increasingly willing to let specialists bend the rules. You’ve got increasingly flagrant situations where if a specialist is long a stock [that is he owns it] he simply raises the offering price, enabling him to make more money on his position. And if he is short a security, he drops the bid price more precipitously, enabling him, to cover his short sales at a better profit. Investors should be up in arms about the way many specialists are handling their securities.

So too, one would imagine, should the SEC. For many years the SEC’s methods of surveillance over the Exchange have been a source of mystery. When for example, do SEC officials visit the Stock Exchange, and what checks do they maintain over the specialists’ practices? These questions were answered in a conversation with an un-named SEC official: Specialists are under the exchange. We don’t get to concerned with them. They’re not directly regulated by the Commission. They all operate under self-regulation. They make their own rules; the Commission just o.k.’s them. Only if the Commission feels there is something not proper does it take exception. We check broker-dealers but we never go onto the Exchange to check out specialists.

Understanding this we can begin to understand why specialists are now being allowed to do quite openly what is still forbidden by the rules of their own Exchange. Formerly, investment bankers and stockbrokers, by acting as their intermediaries, maintained their distance between specialists and institutions. Now that institutions are breaking these ties, specialists are forced with a situation in which they are pitted against each other in order to obtain institutional business. The problem is further compounded for specialists by the inception of the new central market, which presents them with the prospect of increased competition for business from other

Exchanges. Thus institutional traders have been faced with the curious spectacle of the Stock Exchange’s usually arrogant, immovable high priests scurrying around Wall Street, soliciting business like common stockbrokers. For as many years as specialists have been in business, investors have sought to obtain data on their incomes. Not surprisingly, the Exchange has refused to grant access to this information. It would have been absurd for specialists to surrender their income data voluntarily, since it has been through the shroud of secrecy and the lack of regulation that they have been able to turn a humdrum job into a several-hundred-million-dollar-ayear-job. Not only would this data reveal much of the specialist’s Sinbad-like voyage in paradise, but even more importantly, when the years were examined in which he made his fortunes, the figures would reveal the enormous profits for him during a bear market cycle. Self-regulation grants the specialist his power. It is the myths that surround him that sustain that power. Lacking the nourishment of fact about the specialist system, investors have been overfed and underprivileged by the media’s fictions. Chief among these fictions is the belief, firmly embedded in investor consciousness, that the risks and financial losses suffered by specialists far outweigh those suffered by investors. Unfortunately, nothing could be further from the truth. If you have any comment or questions forward them to the link below: [email protected]