Long-awaited changes to the New York Stock Exchanges market structure have arrived in the form of a hefty rule filing that is expected to be fast tracked to implementation later this year. The filing and its associated filings – contains a large amount of both major and minor changes to the specialist model, morphing specialists into designated market makers or DMMs, supplementing existing order types and introducing new dark liquidity functions for all participants. Although this is a major departure from the current model, the new market structure needs to be stacked up against other market models in terms of competitiveness and effectiveness.
First and foremost, the specialist model is being replaced by a DMM model. The label specialist will be consigned to history and the DMM model ostensibly paves the way for new entrants. These DMMs will have obligations to quote, incented by trading rewards and by the potential exclusion from future securities allocations if quoting thresholds are not met. The phasing out of the specialist per se is a welcome move and should please
the antagonists of the model and is equally good for the Exchange which has had to support them.
The DMM model is open to new applicants as well as the existing
specialists, attracted by preferential trading opportunities, being the primary liquidity provider, the pricing of the opening, closing and intra-day imbalances, and security allocation.
As part of the modernisation of the role, the outdated negative obligations have been removed. Specialists have chafed at these restrictions that essentially limit trading to maintaining a fair and orderly market, and which have hindered the specialist from competing with off-floor traders who could trade across the market place without obligation or restriction (or privileges, it must be said). The removal of shackles is of course accompanied by the removal of privilege, i.e. information.
In the current model, the specialist is deemed the responsible broker, and agent, for the orders on his book, which he can see on an order by order basis. As such, these orders come first; therefore, if the specialists quote and a customer order are resting on the book at the same price, and an incoming order does not fill the entire demand or supply, the customers order takes priority. In the new market structure, the visibility of the order flow is reduced and the agency responsibility is limited to times of an imbalance in the market; at other times the DMM is an equal participant. At openings, closings and auctions, for example, the DMM needs visibility over the eligible order flow in order to price the imbalance so that there is continuity of pricing and limited volatility at this time.
As the DMM is now a more equal participant in the market, the parity rules are also being changed. Parity allocation is an important differentiator in the NYSEs execution methodology, although it tends to be little understood and is a convoluted concept. Unlike venues that operate in strict price/time priority, parity allocation allows for resting orders on the book at the same price to receive an allocation of shares from an incoming
order that does not fill the entire demand or supply, irrespective of the time of entry of the resting orders.
This dates to the open outcry market and is the electronic equivalent of several floor brokers standing at the specialists post in a so-called crowd and competing for an order being auctioned off. Most customers are blind to the parity rules, and are only concerned with the favorable fill rates that parity rules tend to give floor participants. When an order book is stacked high with orders at one price, parity allocation matters. Twinned with parity allocation is priority of execution, and the rule changes are designed to encourage tighter spreads and more competitive quoting by better rewarding the establishment of new best bids and offers.
Alongside the removal of privileges and obligations, the Exchange has also removed the contentious algorithmic first look and added new opportunities for price improvement for DMMs, designed to encourage more resident liquidity. This puts the onus on DMMs to be more proactive in their provision of liquidity, with reactive trading reserved for auctions and floor broker activity. This also places DMMs on a par with other participants who may enter non-displayed liquidity. More importantly though, is the opportunity to reduce the latency in the execution process significantly and bring the NYSE turnaround times more in line with electronic competitors.
While the market structure changes are substantial, they must be viewed as transitory and the Exchange will need to keep moving toward a more cost efficient, competitive market model. The changes contained within the rule filing are by and large aligning trading with off-floor and electronic competitors capabilities, but the Exchange still maintains an expensive floor overhead. For DMMs, profitability and opportunity need to be weighed against the technology, staffing, and regulatory costs of floor trading. This rule filing represents a giant stepping stone which sets the scene for further changes but by itself it will not transform the Exchanges fortunes overnight.