Duncan: We'll tie compensation to quoting and providing liquidity

By: Ray Pellecchia

File Under: NYSE

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We've posted the transcript of last week's NYSE Euronext quarterly-earnings conference call, and there are some good comments from Duncan Niederauer about what's going in the NYSE market, and what's ahead. Here are three selected excerpts from the Q&A:

Ken Worthington - JPMorgan - Analyst
...How high were payments made to specialists this quarter? I guess are they acclimating to hybrid? Are the execution statistics improving from where they had been over the last quarter or so? Then, to what extent in the future do you have the ability or willingness to start to reduce those payments, the life support to the specialist system?

Duncan Niederauer - NYSE Euronext - President & Co-COO & Head of U.S. Cash Markets
I think, to go back to what we talked about in the last earnings call, you know, the payment plan is what it is right now. It's I guess just under $9 million a month, collectively, to the specialist group, so call it roughly $105 million or $106 million a year.

As I said in the last earnings call, I'm less interested in reducing that number from $105. I'm more interested in having it tied to performance and market quality metrics. So, I've got a draft of a proposal in front of the SEC now that they responded pretty favorably to. What I would imagine is you will expect to see us, on or about September 1, begin to distribute a similarly sized pool, all other things being equal, but it will be much more tied to quoting performance and liquidity provision performance, which I think are much more closely tied to market quality.

Now, one thing I'm putting in this new plan, or at least contemplating, is the size of that pool could go up if we do a lot more volume; the size of that pool could go down if we do a lot less volume. So I'm trying to align everybody's interest so that the specialist is motivated to perform better and be a more consistent liquidity provider. Their participation rate is down to about 4%. I've said many times I don't think the higher participation rate is directly correlated to higher market quality, but I do think that the more you set the NBBO, the more liquidity you provide at the NBBO and the more flexibility I'm able to give the primary market maker in their ability to hedge the exposure. You know, liquidity begets liquidity and you start to turn it into -- in a very positive direction.

Ken Worthington - JPMorgan - Analyst
Okay. So the first part of the question -- are the execution statistics actually -- are they starting to improve as the specialists acclimate, or are we still at about the same place we were last quarter?

Duncan Niederauer - NYSE Euronext - President & Co-COO & Head of U.S. Cash Markets
Having moderately more success in terms of their ability to take action, because since 290 milliseconds has gone to 100 milliseconds now or 110, the throttling time has obviously gone down commensurately, so they are having a little more success getting involved. There's slightly more (inaudible) available to bid and offer. The fill rates are down a little bit. Volatility is down a little bit. It's hard to separate whether that's them getting more or less acclimated from what's going on since July 9 with the NMS pilot, so I'm still evaluating that. But it seems like it's fairly consistent with last quarter, with some signs of movement, and I think really the rules are going to be -- the rule changes are going to be the key to seeing a marked difference.

. . .

Rich Repetto - Sandler O'Neill - Analyst
...Then the last question goes to Duncan and the topic is about the specialists. I guess what I hear you say is that this proposal you have to the SEC also has rule changes, not only rule changes on how you support the specialists but also rule changes on how they trade, I guess the whole parity issue, because you get really pay them -- at least from what they are saying, they can't perform their jobs until they get some sort of regulatory parity -- not regulatory but, you know, parity in how they can trade. Is that correct or --?

Duncan Niederauer - NYSE Euronext - President & Co-COO & Head of U.S. Cash Markets
Among the rules I have in front of them right now, Rich, none of them is tied to parity. I think it is an issue that has to be addressed.

We've said pretty publicly that, look, a lot of these rules made a lot of sense two or three years ago. I think now that hybrid has been fully rolled out, the market is a lot more electronic, we get to learn from what we've seen in the market. But my point to the SEC is that rules that made sense two or three years ago may have already outlived their usefulness and should be reevaluated.

You know, one could easily argue that one of them is parity. To say to someone who sets the NBBO that after everyone joins them, they go to the back of the line, it doesn't make obvious sense to me or anyone else that I talk to. So you can safely assume that I will eventually put something in front of the SEC on that, but that is not among the rules I put in front of them right now.

. . .

Roger Freeman - Lehman Brothers - Analyst
Duncan, I wanted to follow-up on a couple of things about the specialist business. So I guess I was expecting that the parity rules would have been something that would been addressed at this point. I'm just wondering why that's being pushed out to a later point. Can you also just clarify then what the key issues you are addressing with the SEC now? Is it about the ability to narrow the quote in terms of the increments that they can quote at?

Duncan Niederauer - NYSE Euronext - President & Co-COO & Head of U.S. Cash Markets
I think -- we will get to all of these, Roger. I'm just trying to do it in what I think is the most appropriate and orderly fashion. You also have to keep in mind where the SEC has an appetite, or our clients have an appetite, etc. So I think I'm just trying to do it in what I think is the most sensible order of operation that I've been able to devise.

So what we have already changed is the ability to hedge after 4:00 and before 9:30 AM; that's already done. Because I think the important thing (technical difficulty) liquidity and run bigger positions, then I've got to give them the ability to hedge.

The ones that are down there right now are amending some of the (inaudible) rules that I think are outdated, which you've seen some comment in the press from specialists on. We have a different set of rules for stabilization and destabilization in the S&P 500 as opposed to the rest of the universe. So I'm trying to extend the rules we have in the S&P 500 to all stocks.

Then lastly, the other one I'm working on with them right now is the one you alluded to, which is I think the concerns about pennying were pretty rampant two or three years ago. Given that 96% of our volume is in stocks with a nickel spread or lower, I'm trying to eliminate the price improvement parameters where a specialist, as anyone else would be, is free to improve the quoted spread by as little as $0.01. Even though you can do it by sub-pennies in NASDAQ and that I think what's happened is that rule has eliminated anyone trying to compete inside the spread. I thought that was a more important one to change earlier than the parity one, but I will change it.

I find all of that very encouraging. My takeaway: we're pressing an agenda on several fronts aimed at enhancing market quality. A few of the building blocks are now in place, and the next one is key: tying specialist compensation to performance in quoting and providing liquidity. And that change is coming next month.

Welcome to the workin' week, folks. May the market do better than last week. As Elvis Costello said:

Oh I know it don't thrill you, I hope it don't kill you.
Welcome to the workin' week.
You gotta do it 'til you're through it so you better get to it.

On This Day in 1965: The album "Help!" by the Beatles was released. (NYTimes.com) Most under-rated tune on that disk: "You're Gonna Lose That Girl."

Tags: New York Stock Exchange, Hybrid Market, NYSE, NYSE Euronext, NYX, trading, stock market, Beatles