By Cristina McEachern

Regulat ion, the loss of specialists, electronic trading - they're allan the listw hen it comes to placing blame for recent market volatility.

JANUARY-FEBRUARY 2009 I 21

unbalanced. Specialists assigned toa ce rtain security are obligatedwhen demand goes up to sell theirfirm's inventory or short the stock,often at prices higher than the cur­rent bid/ask spread.

But as electro nic trading hastaken over and the YSE has moved

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cialist firms on the floor today, downfrom more than 40 in the early 1990s.

The specialist conce pt was origi­nally put in place to increase liquidi­ty and ultimately provide more-effi­cient trading. The specialists' role isto ac t as dealers and provide liquidi­ty and depth when the markets are

c...

OLATILITY IS THEnorm these days as

the markets expe ri­ence dramatic ups

and downs amid theglobal financial crisis.

The government announces a bailoutplan - the market tanks. The gov­ernment announces tweaks to thebailout plan - the market jumps.

In fact five of the 10 biggest poin tdeclines on record for the DowJones Industrial Average occurred inSeptember and October of this year.Five-, six-, even seven-hundred­point drops have becom e common­place, and traders have been on aroller-coaster ride of gains and loss­es (see related table, page 22). It's abrave new trading world , andvolatile 'markets re ign.

Many observers have been quick topoint the finger at widespread elec­tronic trading - in particular, pro­gram trading - as the major culpritbehind stocks' wild ride. Programtrading as defined by the ew YorkStock Exchange is "a wide range ofportfolio trading strategies involvingthe [electronic1purchase or sale of15or more stocks having a total mar­ket value of $1 million or more."

Not So Special?Other experts have suggested thatthe industry was too quick to dismissthe specialist model on which theexchanges historically relied. TheNYSE, for example, has just six spe-

sVolatility Continues, thelame Game Heats Up

ADVANCED TRADING

The E-Trading FactorThe growth in electronic tradin gobvio us ly has had an immenseimpact on the markets, having com­pletely rewritten the nature of trad­ing. But its rapid rise has not comewithout consequences.

"We had no choice but to go elec­t:ronic, and fast , with Reg NMS, butno one anticipated the volatility wehave today," says Joe Saluzzi ,cofounder and cohead of the tradingdesk at Themis Trading, a Chatham,N.J.-based agency broker. "The spe­cialists aren't out there to controlthe flow, slow things down.

need in the marketplace: But Levasadds that the market also needsmore st ructure today.

"We used to even have leveragelimits - max was 15-to-1 leverage;now it's 40-, 50-to-l , whatever. Weneed those guidelines and that foun­dation," he says . "Any organization- government, corporations, busi­nesses - all have structure, and weneed structure here:

lated than ever before. So could spe­cialists have made a difference amidthe turmoil? Ultimate ly we willnever know.

Linda Sarkisian , most recentlydirector of trading at OlympianCapital Management and a formerspecialist on the Boston StockExchange for 25 years, believes spe­cialists could have made a differ­ence at the height of volatility, but,she says, the way the mar kets oper­ate tod ay is so different that addi­tional measures st ill wo uld havebeen necessary to calm the markets .

"There is no one responsible forthe market [today) - the specialistswould help ," she asserts. "But inorder for them to be able to do theirjobs, there is going to have to beother regulation to go with it and amore centralized marketplace."

According to Ft . Lauderdale­based Olympian's founder and chiefinvestment officer, Michael Levas ,"Specialists add a lot of credence tothe market - a certain amount ofconsistency and a reliability that we

to a hybrid model, specialists don 'thave the same incentives, and as aresu lt the markets are very differenttoday, as there is no liquidity guaran­tee in volatile times.

In addition to the influx of elec­tronic trading, since the heyday ofthe '90s the markets have seen manyother changes, including the move todecimals, which narrowed spreadsand decreased average trade sizes;the repeal of the Glass-Steagall Act,which separated com merci al andinvestment banking; and the removalof the uptick rule. (The uptick rulerequired that sho rt sales occur onlyat a price that is higher than the priceof the previous trade to preventshort sellers from contributing to thedownward spiral of a securi ty's pricein volatile times.)

Could It Have Been Different?Most expe rts agree that the root ofcurre nt volatility doesn't trace backto one cause, but rather is a culmina­tion of events that have left the mar­kets more fragmented and less regu-

2008-10-13 9,387.61 9,427.99 8,462 .18 965.81 +936.42

3 2008-11-13 8,835 .25 8,876 .59 7,965 .42 911.17 +552.59

4 2008 -10-28 9,065.12 9,082.08 8,174.73 907.35 +889.35

5 2008 -10-09 8,579 .19 9,448 .14 8,579 .19 868 .95 -678.91-f

6 2008- 10-16 8,979.26 9,013.27 8,197.67 815.60 +401.35

7 2008 -10-06 9,955.50 10,322 .76 9,525 .32 1797.44 -369.88

8 2008-10-15 8,577.91 9,308.76 8,530 .12 778 .64 -733.08

9 2008-09-29 10,365.45 11,139.94 10,365 .45 774.49 -777.68

10 2000-04-14 10,305.77 10,922.85 10,201.53 721.32 -617.77

Source:The Wall Street Journa l Histor ical Index Data

22 I JANlJARY'FEBRlJARY 2009 '~ww.advancedtrading. com ADVANCED TRADI NG

-Michael Levas. Founder and Chief Investment Officer.Olympian Capital Management

"Specialists add a lot of credence to the market - acertain amount of consistency and a reliability thatwe need in the marketplace."

with it and a more centralized mar­ketplace - .. . a place where every­body else could access this market-

place - then maybe we wouldn'thave these [precipitous) drops."

JANUARY'FEBRUARY 2009 I 23

Curb AppealThemis Trading's Saluzzi also hassome ideas to help slow the volatili­ty. "We can't get the specialist sys­tem back, but we can put back the 2percent curbs to slow down the pro ­gram [trades), the spark igniting thefire," he says, adding, "They come inand you can feel them coming in,then the algas start chasing them."

Two percent curbs, or trading col­lars , were put on brokerage firmsthat used program trad es when theNYSEComposite Index moved up ordown more than 2 percent. The rulewas removed in October 2007 whenthe exchange determined that therule was no longer effective in curb­ing market volatility.

Saluzzi also says the implementa­tion of a full one-second holding peri­od before a trader can cancel an ordercould help ease volatility. "Therewould be no more immediate cancels[from] the guys who are putting quotesall over and clogging the data pipes,"he points out. "If we slow down thevolume of the la Cs, we might be ableto slow down the volatility."

Despite his ideas, Saluzzi sug­gests, mark et cras hes are somewhatinevitable and each needs to be han­dled on its own terms. "Look at1987," he offers . "We had specialists ,we had the uptick rule and the mar­ket crashed worse than now." 0

ture and consider all costs. "Thespreads may be lower, but howmany shares can you get done ?" she

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Calming the VolatilitySo what are some possible solutionsto ease mark et volatility?

"[For) certain stocks decimals arenot right, and there should be someminim um price increment,"Sarkisian contends. "Google, forexample, sho uldn't be trading at apenny." In other words, trading high­priced stocks such as Google, whichtrades in the hundreds of dollars pershare, might be less volatile if theincrement per trade was , say, 5 or 10cents as opposed to a penny.

"If you had minimum incrementsfor certain stocks, maybe we couldput the uptick rule back. But for lightnow, the way the markets are trading,I don't think it's fair to have theuptick rule in place ," Sarkisian says .

"I can 't say, 'Let's bring b,\ck thespecialists and it will so lve the prob­lem'; it won't - we need othe r thingstoo," Sarkisian adds. "Specialistswould help. But in order for them tobe able to do their job , there is goingto have to be other regulation along

asks. "Are we doing better now thanwe were then?"

While Sar kisian is convinced thatadditio na l specialists could helpredu ce volat ility, she conce des thatthe cur re nt market environmentcanno t support the specialistmode l. "There is no incentive forspecialist s anymore," sh e argues ."It's hard for them to operate in thispenny environment."

"Now it's a free-far-all - the spe­cialists are not in the middle," hecontinues. "Programs are running

ADVANCED TRADING

'A Free-for-All'"Now it's a free-for-all," Sarkisiancontinues. "But this is what institu­tions wanted - they felt they could­n't trade [efficiently] because a spe­cialist was there buying in front ofthem, and they felt they were payinghigher spreads."

Noting that as spreads narrow,trade sizes decrease and fewer blocktrades can be matched, which intum boosts volatility, Sarkisian addsthat firms need to look at the big pic-

wild, algo guys are chasing the pro­gram guys. It becomes a vacu um andbids drop, everythi ng disappears ­the vicious se ll-off that chases itse lfdown and no one is there to stop it."

Olympian's Sarkisian recalls thetime when specialists were every­where and fractions were still thenorm. "Back with the specialists andthe fraction mark et, maybe peopledidn't like those spreads, but the rewas more fluidity and things werenot gyrat ing all over," she asserts."Specialists were there and the bookwas there, and there was less frag­mentation of the market."

With the specialist model all butextinct, and without a price-discov­ery mechanism in one place, volatil­ity has set in, Sarkisian adds. "Thespecialist model was not perfect, butthey did have a responsibility to buyon the way down and sell on the wayup. They had a responsibility to themarketplace," she points out.

J