Applying the Concept:  Are Specialists an Endangered Species?                          

Specialists are the mainstay of the floor of the New York Stock Exchange.  Each of the 2500+ NYSE-listed stocks is assigned to one of the seven currently operating. Specialists are market makers whose job it is to provide liquidity and cushion volatility.  If you want to buy or sell a share of stock in a company listed on the NYSE, and the order goes to the floor of the exchange, the specialist is charged with ensuring that your ordering is executed fairly.

Electronic Communications Networks operate without specialists. If you want to buy or sell a share of stock one of these, you can just post your order on the electronic order book for everyone to see.  Since anyone can offer to buy and sell, anyone can be a market maker. Liquidity on an ECN doesn’t come from a specialist; it comes from the people who are participating.

When the NYSE and merged with the largest ECN, Archipelago, it introduced something called a “hybrid market” that offered investors a choice. They can trade either through a specialist on the floor or on the electronic network. The idea was that some customers trading some stocks would choose one and some would choose the other.  Will they?

There are really two types of stocks out there – those that trade frequently in large quantities, and those that trade rarely in small amounts.  The first are companies that everyone has heard of -- GE, Microsoft, IBM, and the like.  A given day’s volume in the stock of one of these companies could easily be 25 million shares. The second group includes companies know nothing about, not even their names.  Culp Inc., a 2000-employee North Carolina manufacturer of mattress coverings that has less than $300 million a year in sales is an example.  And during a trading day, less than 5,000 shares of Culp Inc. might trade.

No one needs a specialist to buy and sell GE.  You can do it on an electronic exchange where there are often thousands of orders waiting.  It’s for the small, rarely traded stocks, that you need a specialist.  Or that’s the claim.

The problem is that specialists’ profits come from trading in the big companies – by one estimate, as much as 90% of their revenue is from the companies like Lucent and BellSouth.  With the small company stocks, making a market often means buying shares and holding them for days or weeks – that is, making a real investment in the company.  But specialists are not well-suited to be investors in small firms.  That’s not where their revenue comes from.

So, with trading in the big companies moving onto electronic exchanges, and trading small ones unprofitable, it looks like there isn’t much left for specialists to do.  And when they go, there won’t be any need for the floor of the New York Stock Exchange. Maybe they can make it into a museum.