The nation's oldest monopoly is breaking down under the combined forces of federal pressure, new technology and old-fashioned competition. After two centuries, the New York Stock Exchange is losing its ancient monopoly position and the extraordinary profits that go with it.
The exchange was once a natural monopoly. A central market for stocks is inherently most efficient and the need to gather brokers in one place to communicate their orders meant that the central market had to be a local one. History ordained that the location of the central market would be in lower Manhattan.
Today, a central market can be a national one. Modern telecommunications technology enables brokers all over the country to compete in making markets for stocks. The exchange no longer enjoys a natural monopoly, but rather an artificial one based on old rules and practices. Changing those old rules and practices is the principal issue in creating a competitive national market system.
The heart of the exchange's monopoly is the specialist system. Current rules force member firms to bring their buy and sell orders to the specialist on the floor of the exchange, giving the specialist a monopoly of knowledge about trading conditions. He then uses that knowledge to set the price at which a stock will trade.
He also uses his monopoly of knowledge to make extraordinary profits for himself by trading for his own account. In the brokerage business, knowledge is not only power but profit as well. Annual incomes earned by specialists often run into several hundred thousand dollars. Maintaining those extraordinary incomes is the principal reason the exchange wants to maintain the status quo.
The year 1975 was a watershed for federal pressure on the NYSE to end the status quo. The Securities Exchange Commission outlawed price-fixing of brokerage rates, a standard practice until then. Congress passed the Securities Act Amendments, stating its goal of a national market system to promote efficient execution of securities transactions and fair competition.
Congress left the details of a national market system to the SEC, which in turn left them to the securities industry that agrees on little except maintaining the profitable status quo. The ensuing struggle to establish a national market system demonstrated the German proverb, "The devil is in the details."
The details of a national market system involve innocuous-sounding rules that are fought over with a passion normally reserved for religious crusades. The exchange's Rule 390 forces member firms to bring their buy and sell orders to the specialists, so changing that rule is the major point of contention.
Pressure from the SEC led to a new rule that weakens Rule 390 for about 130 stocks. Rule 19C3 gives member firms the option of taking their orders to the exchange's specialists or executing the orders within their own firms. While Rule 19C3 chips away at the power of the specialists, it fragments the total securities market rather than promoting the central market that Congress intended.
A central market requires some mechanism to link competing markets and to ensure that the order goes to the best market. The electronic technology to link competing markets already exists in the form of the Intermarket Trading System (ITS), but brokers are under no obligation to use it. Standard practice in the brokerage industry is to route orders automatically to the Exchange without checking to see if a better market is available elsewhere.
The SEC's latest proposal is to route orders away from the exchange is a better price is available in some other competing market. By building on the existing ITS and the quotation system of the National Association of Securities Dealers, the SEC hopes to force more effective competition by ensuring that the most competitive market-maker gets the order.
The role of the SEC in developing an effective national market system is controversial. Under Chairman Harold Williams, the SEC has adopted a slow, evolutionary approach that seeks to reform the system without wrecking it. The slow pace of progress recently led the oversight and investigations subcommittee of the House Commerce Committee to criticize the SEC for "timidity and apparent purposelessness."
The forces of competition have been anything but timid and slow. Most specialists do not make markets deep and liquid enough to satisfy large institutions such as pension funds and bank trust departments. The need to trade their large blocks of stock is satisfied by institutional brokers who often bypass the specialists and then merely record their transactions on the exchange's tape. For large institutions that comprise the bulk of trading in listed stocks, the specialist is becoming far less important than he once was.
Large institutions are sophisticated enough to bypass the exchange's specialists, but most individual investors are not. The rich take care of themselves quite well, but small investors depend on the current system that does not ensure the best execution of their orders. The SEC's latest attempts to see that orders go to the best market will, if successful, accomplish the twin objectives of promoting a central market and protecting small investors who need protection the most.
The exchange is fighting a rear-guard action to maintain its specialists' ancient monopoly. Their reluctance to change comes not just from a fear of losing monopoly profits, but also a fear of new technology. To specialists still operating with 18th century methods, 20th century technology looks like the camel's nose under the tent of changes that will revolutionize their jobs and perhaps eliminate them.
Their fears of new technology are well-justified. Many brokers who have spent their professional lives waving orders and shouting will not make the transition to a new system that executes orders by computers and cold video display units. They fear that Merrill Lynch's chairman, Donald Regan, was right when he said: "The future is the so-called 'black box' . . . because it is ultimately a lot more efficient and cheaper than the present system."
All this means a revolution in the way the exchange does business. After two profitable centuries as a price-fixing monopoly, the exchange lost its price-fixing powers and now is losing its monopoly powers as well. Practicing competition is less profitable than merely preaching it, which is why the NYSE is trying so hard to prevent a national market system. A competitive national market system is not yet a reality, but it is an idea whose time has come.