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CNBC's Pisani: Specialists Tell NYSE's Thain They Need Help Now

Bob Pisani
Thursday, 22 Feb 2007 | 7:02 PM ET

The heads of the major specialist firms met with NYSE CEO John Thain Wednesday and gave him a simple ultimatum: Help us out, or we are getting out of the specialist business.

The specialist business has been under pressure for years, beginning with the move to pennies in 2000, which dramatically cut profits. Then they were required to pay massive fines for violations of trading rules (and in some cases, criminal charges were brought against individual specialists).

The move to a Hybrid trading platform in December 2006 exacerbated their problems. Hybrid gave NYSE customers what they wanted: access to electronic trading of NYSE stocks, along with the continuation of floor trading, where brokers and specialists could offer price improvement.

Good in theory, but things have turned out differently. Specialists have found it very difficult to participate in trading against electronic trading; their "participation rate" -- the rate at which the take part in trades -- has dropped dramatically. LaBranche, for example, said its participation rate dropped to 14%, the lowest figure on record.

Part of the problem is that specialists have been forced to develop algorithmic trading programs to interact with the electronic market, since they cannot do it by simply observing the market by eye. These trading programs have had difficulty interacting with the electronic order flow, partly for technological reasons (some specialists claim their orders are "kicked out" by trading systems that can't handle the traffic), and partly because they may lack the sophistication to adequately make money for specialists.

Specialists have also complained that the rules governing hybrid trading are confusing and, specialists claim, often illogical.

Result: Profits have plummeted. Specialists are must maintain a $100 million capital requirement due to the risks of trading; but with 2% returns on this investment (for one firm), risks often outpace rewards.

Perhaps most alarmingly, there's evidence that the move to Hybrid has resulted in a decline in price improvement, which traditionally was one of the main claims for why floor-based trading was superior.

The bottom line: Specialists have asked Thain to go the SEC and request changes in the way Hybrid allows them to trade. These include reducing the $100 million capital requirements, which will free up money for other purposes.

The NYSE has refused to comment on these meetings, saying it does not comment on internal discussions.

What's clear is that the specialists are under tremendous pressure, and this will not continue for long without help.