The Securities and Exchange Commission will send a team of investigators to New York Monday to look into possible illegal trading by some of Wall Street's biggest specialist firms, sources said yesterday.
Sources close to the investigation described the action as a fact-finding mission to assess both what the New York Stock Exchange, which confirmed this week that it is reviewing trading practices at several specialist firms, has learned and how the exchange is handling the situation.
At issue is whether any of the NYSE's seven specialist trading companies, which match buyers and sellers on the floor under the exchange's unique auction system, unfairly profited on trades at the expense of the investing public, a practice known as front-running. Specialists occupy booths on the exchange floor and conduct trading in a set group of stocks. Although they can legally trade for themselves, specialists are not allowed to execute trades in a way that favors their own accounts at the expense of other investors' orders.
The SEC first learned this week about the NYSE investigation -- and about a similar but separate internal probe by one of the firms under scrutiny, FleetBoston Financial Corp., the sources said. So far, neither the NYSE nor FleetBoston, which has put one specialist on administrative leave, has concluded that any laws were broken, the sources said.
The NYSE stock investigation was reported this week by the Wall Street Journal.
Publicity about possible illegal trading comes at a sensitive time for SEC Chairman William H. Donaldson and the Bush administration, as they struggle to restore confidence in the nation's markets and in the SEC, the federal agency that regulates them.
Investor trust has been shaken by a series of corporate scandals that began 18 months ago with the fall of energy trader Enron Corp., and by controversy during the same period over how Donaldson's predecessor at the SEC, Harvey L. Pitt, ran the agency. Allegations of bogus stock research and improper allocations of initial public offering shares have also shaken trust in Wall Street.
Donaldson, who took the helm of the SEC nine weeks ago, after Pitt was pressured to resign, served as chairman of the NYSE from 1991 to 1995. During that time, senior exchange officials reexamined and gave quiet approval to a practice of allowing floor brokers to trade and share in profits with private clients, a practice the NYSE defended as legal at the time. Five years later, federal prosecutors indicted and convicted a handful of brokers for engaging in this practice.
During Senate confirmation hearings in February, Donaldson defended his tenure as exchange chairman. He told lawmakers he was more active in trying to prevent abuses than has been reported.
The possibility of illegal trading also comes at a sensitive time for the NYSE, a self-regulatory organization overseen by the SEC. The NYSE and NASD, the other market self-regulatory organization, have been accused of lax enforcement of their own rules during the stock boom of the 1990s.
Institutional investors, such as big mutual fund companies, have complained for years that improper trading by specialists has cost their investors huge sums of money. Market experts say individual investors attempting to buy and sell shares through the NYSE's auction system, in which a human being rather than a computer matches buyers and sellers, also can be hurt by front-running.
Essentially, the abuse could work this way: An individual investor wants to buy shares in Company X at $20. The investor's brokerage firm transmits the order to a floor broker at the exchange. The broker takes the order to a booth on the floor, where a specialist conducts trading in Company X's stock. The specialist is supposed to match the investor's buy order to a sell order at the best possible price. Illegal front-running occurs when the specialist uses his knowledge of the pending $20 buy order to buy shares for his own account, knowing the stock he is buying will go up.
After buying for himself, the specialist executes the individual investor's order -- but at a higher price, perhaps $20.10. The specialist can then sell the shares he purchased and take advantage of the increase in price caused by the buy orders. While individual instances of front-running may only account for a few thousand shares, front-running profits can add up quickly in a market that trades over a billion shares a day.
Benn Steil, an expert on financial markets at the Council on Foreign Relations and a critic of the NYSE's auction system, said front-running tends to emerge in down markets such as the current one, when low volume cuts into commissions that specialists make on trades. "The only way for specialists to make money [in the current environment] is for them to know something that others don't. And the only thing they know is the other orders that are out there," he said.
Kenneth Morris, a veteran of Morgan Stanley and a fierce critic of the NYSE's trading structure, said the fact that past investigations have turned up repeated instances of front-running and other abuses, often punished only by censure and a small fine, demonstrates that the exchange is incapable of operating as a self-regulatory body.
"At a minimum the self-regulatory structure has to go by the wayside," he said. "Would we have let Arthur Andersen investigate itself? Or a group of senior executives in the energy-trading industry investigate Enron? Of course not. But that's what's been going on at the exchange for years."
An NYSE spokesman did not return a call for comment. In an interview on CNBC on Thursday, exchange Chairman Richard A. Grasso defended the auction system. From "the largest customer to the smallest customer, I can promise you your order has been treated fairly. And if it hasn't, the person who hasn't treated it fairly will be out of the business," he said.