Specialists' Investment Accounts By Richard Ney

Specialist Investment Accounts The ability of specialists to possess and to trade in their own investment accounts should be a source of great consternation to investors. It is very easy to understand this phenomenon once one understands that a revolving door exists between the Stock Exchange and the SEC. For example, just prior to the investigation of E.F. Hutton for thousands of frauds in 1981, John Shad, the Vice Chairman of E.F. Hutton, was appointed Chairman of the SEC. Having left the SEC, he is returned to the investment business as Chairman of Drexel, Burnham. The revolving door is one reason why the specialist system has been allowed to perfect its goals of profit maximization rather than the goals appropriate to its function as a fiduciary. Rather than serving in accordance with their statutory requirements as fiduciaries specialists are allowed by the SEC to act in competition with investors. Their ability to trade and invest for themselves has given them a stake in the direction in which they move stock prices. At the same time, the mere existence of their trading and investment accounts leads to certain predictable patterns of behavior by specialists specifically, patterns of behavior which tend to maximize their profits. This, in turn, gives the astute investor, who is willing to make the effort to learn these behavior patterns, an important key to unlock the markets future. Of course, the ultimate solution to the problem of the specialist system is to do what has been done in other institutional frameworks where conflicts of interest would be detrimental. For hundreds of years, it’s been the maxim of English common law that no man should serve as judge and jury in his own case. Everyone, even if he or she has never studied the law, understands intuitively why this should be so. Indeed, one of the triumphs of our legal

system is that it has erected structural safeguards to blunt the natural tendency of men to pursue their own self-interest in a situation where it’s not appropriate. If the system has failed in the case of the Stock Exchanges, it is because the SEC the agency that is supposed to regulate and make the laws governing the Exchanges, expressly provides for the securities industry’s representatives to dominate its advisory boards and act as its chairman and commissioners. In effect, the Exchanges make the regulations to which they are presumably subject to. Thus there exists within the Exchange establishment an institutional arrangement which not only does not thwart the tendencies to self-interest, but which encourages it. The result is an institution, which exists for the benefit of those who are able to manipulate its institutional privileges to their own advantage. To fully understand the problem, it’s important to recognize that it begins with the individual known as the specialist. Specialists do not work for the Exchange they are the Exchange. They are the brokers on the floor of the Stock Exchange given the responsibility “to maintain a fair and orderly market” for the stocks assigned to them. There are several hundred specialists on the floor of the Exchange, divided into approximately 50 units. Each unit handles the buy and sell orders in as few as 10 issues to as many as 50 or more stocks. Since each specialist unit is located at one locale on the Exchange floor “called the post”, all buy and sell orders for issues are handled at one spot. The orders placed with one’s broker eventually find their way to the specialist on the floor of the Stock Exchange. One of his functions is to then match as best he can

the public’s buy and sell orders. Because all orders flow through him, the specialist is suppose to possess the best overview of the demand and supply factors that should determine the price of the issues assigned to him. He is, therefore, charged with the uniquely sensitive task of setting an appropriate or fair price for his stocks.

allowed to maintain an investment account. The existence of this account gives the specialist the same trading incentives as any profit-seeking figure. He wants to buy low, to sell high and to do so with a minimum of tax consequences. The only trouble is that he is not just any profit seeking figure.

When the investor hears that GM has closed up ½ or that IBM has moved down 2 ¼, he should understand that this literally means the specialist-set price in IBM was 2 ¼ points lower on the second day than the first. We shall see, however, that more than public supply and demand factors impinge upon the specialist’s decision-making process of what price to set for his issue.

The specialists access to the most sensitive market data, the universe of demand and supply orders, as well as his ability to set the price of his issue, puts him in a situation where it is impossible for him to fulfill his duty as a fiduciary. The equivalent situation in the legal world would be to let one act as a judge in his own case.

To understand the source of these other factors, it is necessary to explore a bit further the nature of the specialist’s operations. Those few individuals who know anything about the specialist probably have heard that he is supposed to maintain a fair and orderly market. One way he is supposed to accomplish this is to act as a source of market liquidity. Every stock that is traded on the New York Stock Exchange is assigned to a specialist, and every specialist stands as a miniature warehousing operation for the stocks he’s been assigned. Theoretically, any “excess” public demand for an issue would be met by selling distribution from the specialist’s principle warehouse, better known as his trading account. On the other hand, when there is “to much” public supply or public selling, the specialist is supposed to open his warehouse (trading account) to mop up or accumulate these excess quantities of stock. Whatever legitimacy specialists trading accounts might have because of there role in maintaining market liquidity, they more than lose once one discovers that in addition to a trading account maintained for warehousing purposes, the specialist is also

A special investigators team of the Securities and Exchange Commission recognized the inherent conflict of interests in 1963 when it studied the market crash of 1962. In its report, the commission wrote, “purchases made on the Exchange for the purpose of segregation into long term investment accounts raised problems which go to the heart of the specialists 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 long-term position now has a stake in seeing that the security rises 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”.

Of course, the last point, about the 12 month statute, was written at a time when there were special tax incentives to hold an issue for a period of time. The period has and continues to be as long as a year. Since specialists are investors and are just as anxious to minimize the tax consequences of their trading as you and I, we also believe that bullish phases of the market in the future will tend to match whatever period of time is deemed necessary to obtain favorable tax treatment. Not surprisingly, the Chairman and Commissioners of the SEC chose to ignore the reforms recommended by the staff they had gathered to carry out Congress’s mandate for an investigation of the Stock Exchange practices. Human nature being what it is, one should not be surprised to see the specialist use his unique position to further his own interests - - which he does every minute of every day. It is no exaggeration to state that by the very nature of the situation in which they have placed themselves, specialists conduct insider trading from the moment the opening bell rings until the moment the market closes! There has, of course, been a stream of troubling news flowing from Wall Street as the improprieties of figures such as David Levine, Roger Winans, Ivan Beosky, Boyd Jeffries, Mike Milken, and others have been disclosed. The direct harm caused to individuals and corporations by the illegal actions of these men cannot be underestimated. It is ironic, however, that the fact of the discovery of their misdeeds has had an unrecognized consequence. It has reassured the small investor that the financial establishment’s regulatory agencies are actively and productively working on his behalf. More than ever, he probably believes that the system works - that all which stands between him and the operation of squeaky clean securities

markets are the occasional misdeeds of these so-called insiders. Nothing could be further from the truth. This country’s regulatory agencies, such as the SEC, are concentrating their energies on the wrong “insiders”. Thus, the investing public has developed a false sense of security in the integrity of the financial markets. If one begins, using the premise that the market’s true insiders are Stock Exchange specialists, and that they will do anything they can to profit from their position at the center of the market, then certain points of departure begin to emerge from other sorts of market analysis. The most important of those is our focus on the specialist as a merchant seeking to buy low and to sell high for his investment account. If the specialist has for the most part been accumulating in his investment accounts, he can be expected to use his control over price to rally his issue. If the specialist has sold stock from his investment account and, furthermore, if he has sold short, then the specialist can be expected to use his control over price to drop the price of his stocks. Since I believe one can do no better than to piggyback the actions which specialists are taking for their investment accounts, my approach centers on determining whether specialist have been accumulating, distributing, selling short or covering earlier short sales in these accounts. I then conform my strategies as closely as possible to those specialists. Of course, the question which logically arises is whether there is some way to identify which of these specialist merchandising operations is underway - - a specialist fingerprint that would enable you or I to identify such specialist transactions. I noticed on the ticker tape that time after time big blocks of stock were traded both at the top and the bottom of the stock’s price

pattern. These blocks seemed to herald a forthcoming reversal, but at first I did not understand why they appeared. I learned subsequently that at the top such blocks signify a specialist sale, a specialist short sale or a combination of the two; while at the bottom these blocks reflected transactions in which the specialist covered his short position and went long before rallying his stock. Of course, over time, the size of the blocks that show that important specialist activity is underway has grown considerably. Nevertheless, it is just as true as it was 25 years ago that when big block activity occurs in an issue a turning point will have been reached in the price history of that stock. Furthermore, in the market as a whole, when a large majority of specialists are conducting the same type of big block activity, bull and bear markets are sure to follow. It was enormous specialist accumulation at the lows of late 1986 and early 1987 that fueled the rise of the market to historic highs in the spring and summer of 1987. It was the massive specialist selling and short selling which was then responsible for the crash, which specialists launched in August, and which ended with the 508-point decline of October 1987. Despite the evidence to the contrary, the Stock Exchanges will seek to persuade you that its specialists are passive instruments subordinate to market forces. The argument is deeply at odds with common sense.