'*'ffi,*ffi #-ffiffiffiwffi ffi@ Mf W%*etr%u.Ww";f fWayne H. Wagner



Chief Investment Officer Edward C. Story Client Communication


SERVICES PROVIDED TO Institutional Investors Investment Managers Institutional Traders
Plan Sponsors

Larry J. Cuneo
Portfolio Research and Operations


February, 1988
(Excerpted from a speech given by Wayne at the Market Liquidify Conference sponsored by the Investment Management Institute on February 8, 1988)

The rules of the New York Stock Exchange are designed to centralize all trading into one location, no matter how large or how small the trader. When we observe other market mechanisms, we see that this blending of large and small transactors is unusual indeed. Individuals certainly do not expect equal access to bond or gold or US Treasury Security dealers. Yet we insist on this rule for I.IYSE transactors. The key question is whether such a scale-less
market best meets the needs of either institutions or individuals.

In California we have a law that keeps mopeds and other such underpowered vehicles from venfuring onto the freeway, where they are likely to suffer harm in the way of more
massive and faster moving vehicles.

Iarly widely accepted in Congress and the SEC, who seem ever ready to step in to defend the
interests of The Common Man.

Assuredly, mopeds would be fine on the freeway if all they encountered there was other mopeds. An extreme egalitarian might argue that mopeds have equal right to access to the freeway: since

mopeds cannot deal with massive vehicles traveling at high speeds, these other vehicles must be restricted in their actions so that they pose no threat to moped riders.
One envisions egalitarian freeway traffic moving along at 2A mph. (Not that there aren't times when Southern California drivers would view 20
mph as highly desirable!)

On the New York Bond Fxchange, the small investor market is separated from the bond dealers who service institutional investors. On the New York Slocft Exchange, in contrast, we operate under the quaint assumption that only one market is needed to service both indMdual and institutional investors.
So what? Well, most of the time, it doesn't seem to make much of a difference. When markets are reasonably buy/sell balanced and the physical facilities are adequate to the crush, large and small investors mix without
substantial interference.


similar egalitarian philosophy seems to guide". the conduct of business on the New York Stock Exchange floor. According to the exchange traditions we all accept, the small investor has a right to meet the large investor on "a level playing field." This view seems even particu-

times of extraordinary volume and rapid movement, however, a different picture emerges: one that cannot -- and we would argue should not balance the interests of all parties
regardless of their size.


Consider the response of the market makers to
f!. i.": j


substantial selling pressure. (Market makers


used here includes specialists, upstairs markets, and other liquidity providers.) Like any merinventory at a higher price than he buys it. In the process, he must cover his costs of conducting business. If an anxious seller demands immediate execution, the market maker will buy it ftom him, but only at a price lower than he expects to sell the merchandise for.



market maker survives

by selling

specialists are evaluated, covering such issues as continuity, spreads, and price adjacency, are of lesser interest to institutions yet dominate the functioning of the market.

The risk of holding inventory until it can be sold is directly proportional to the trade size or, equivalently, the time the market maker expects to hold the inventory. The larger the trade relative to the market maker's risk bearing capacity, the lower the price will be to the seller. Thus prices fall below equilibrium
value as market makers accumulate inventory.

The physical floor of the New York Stock Exchange can only handle so many bodies. When the order flow swamps the physical capacity, the system begins to break down physically as well as functionally. Until we have complete electronic access to the market making capability, the hired representatives (floor brokers) of large investors will crowd out the small investors, even on the DOT system
specifically designed to handle smaller orders.

Note that the level of the price changes, but not necessarily the bid/asked spread. The price to any small investor will look very much the same in terms of the bid-asked spread. The price he pays or receives, however, will reflect street inventory, even though he has no
material effects on that inventory.

How would a separate market making function for individual stock investors operate? By necessity, it would be efficiently and electronically operated. It would probably be a dealer market, like a retail store. This is much like the specialist operates today. Volatility might be less but spreads would be wider due to the
higher cost of ticket processing.

Thus the prices paid/received by individuals are

swept along with the inventory effects of
institutional traders.

What would the NYSE look like stripped of the myth of accommodating the individual investor? Most of the time, not much different. In times of rapid movement, however, the weakness of

Myth has

it that the specialist is some sort


relying on specialists' individually accumulated capital would be glaringly apparent. Mechanisms would evolve to draw together the now scattered sources of liquidity. That alone would

Horatio-at-the-bridge, with the capacity to stem the tide of one-sided markets. This is not true: the specialist has very limited capital, particularly when viewed alongside the money power of








institutional investors.

In a one-directional


bearing capacity is limited by his personal fortune. If October 19th-style sellers come in relentless waves like the proverbial Chinese Army, market makers soon exhaust their ammunition (risk bearing capacity) and stand aside while the market rushes unimpeded to its
own level.

market, the specialist accumulates only as much as his risk bearing capacity allows. His risk

A General Partnership

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extracts from this material with credit given to Plexus Group, 606 Wilshire Boulevard, Suite 200, Santa Monica CA 90401. Tel. (2I3) 451-5075.

Thus institutional investors -- quite innocently and "appropriately" -- can create disorderly market conditions when market makers might have easily accommodated individuals acting in

Nor are institutional investors better served by this mixing. Many of the rules by which

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