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Wayne H. Wagner

Chief Investment Officer

Edward C. Story

Client Communication

Larry J. Cuneo

Portfolio Research and

Operations

SERVICES PROVIDED TO

Institutional Investors

Investment Managers

Institutional Traders

Plan Sponsors

THE MOPED LAW

MONTHLY COMMENTARY #15

February, 1988

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

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

In California we have a law that keeps mopedsand other such underpowered vehicles fromvenfuring onto the freeway, where they are

likely to suffer harm in the way of moremassive and faster moving vehicles.

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

mopeds cannot deal with massive vehiclestraveling at high speeds, these other vehiclesmust be restricted in their actions so that theypose no threat to moped riders.

One envisions egalitarian freeway traffic movingalong at 2A mph. (Not that there aren't times

when Southern California drivers would view 20mph as highly desirable!)

A similar egalitarian philosophy seems to guide".

the conduct of business on the New York StockExchange floor. According to the exchange

traditions we all accept, the small investor has

a right to meet the large investor on "a levelplaying field." This view seems even particu-

Iarly widely accepted in Congress and the SEC,who seem ever ready to step in to defend theinterests of The

Common Man.

On the New York Bond Fxchange, the smallinvestor market is separated from the bonddealers who service institutional investors. Onthe New York Slocft Exchange, in contrast, weoperate under the quaint assumption that onlyone market is needed to service both indMdualand institutional investors.

So what? Well, most of the time, it doesn'tseem to make much of a difference. Whenmarkets are reasonably buy/sell balanced and

the physical facilities are adequate to thecrush, large and small investors mix withoutsubstantial interference.

In times of extraordinary volume and rapidmovement, however, a different picture emerges:

one that cannot -- and we would argue shouldnot balance the interests of all partiesregardless of their size.

Consider the response of the market makers to

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substantial selling pressure. (Market makers as

used here includes specialists, upstairs markets,and other liquidity providers.) Like any mer-chant, a market maker survives by selling

inventory at a higher price than he buys it. Inthe process, he must cover his costs of conduc-ting business. If an anxious seller demands

immediate execution, the market maker will buyit ftom him, but only at a price lower than he

expects to sell the merchandise for.

The risk of holding inventory until it can be

sold is directly proportional to the trade size

or, equivalently, the time the market makerexpects to hold the inventory. The larger thetrade relative to the market maker's riskbearing capacity, the lower the price will be tothe seller. Thus prices fall below equilibriumvalue as market makers accumulate inventory.

Note that the level of the price changes, butnot necessarily the bid/asked spread. The price

to any small investor will look very much thesame in terms of the bid-asked spread. Theprice he pays or receives, however, will reflectstreet inventory, even though he has nomaterial effects on that inventory.

Thus the prices paid/received by individuals are

swept along with the inventory effects ofinstitutional traders.

Myth has

itthat the specialist

issome

sort ofHoratio-at-the-bridge, with the capacity to stem

the tide of one-sided markets. This is not true:the specialist has very limited capital, particu-

larly when viewed alongside the money power ofinstitutional investors. In a one-directionalmarket, the specialist accumulates only as muchas his risk bearing capacity allows. His riskbearing capacity is limited by his personal

fortune. If October 19th-style sellers come inrelentless waves like the proverbial Chinese

Army, market makers soon exhaust theirammunition (risk bearing capacity) and stand

aside while the market rushes unimpeded to itsown level.

Thus institutional investors -- quite innocently

and "appropriately" -- can create disorderly

market conditions when market makers mighthave easily accommodated individuals acting inconcert.

Nor are institutional investors better served by

this mixing. Many of the rules by which

specialists are evaluated, covering such issues

as continuity, spreads, and price adjacency, are

of lesser interest to institutions yet dominatethe functioning of the market.

The physical floor of the New York StockExchange can only handle so many bodies.

When the order flow swamps the physicalcapacity, the system begins to break downphysically as well as functionally. Until wehave complete electronic access to the marketmaking capability, the hired representatives(floor brokers) of large investors will crowd outthe small investors, even on the DOT system

specifically designed to handle smaller orders.

How would a separate market making functionfor individual stock investors operate? Bynecessity, it would be efficiently and electroni-cally operated. It would probably be a dealer

market, like a retail store. This is much likethe specialist operates today. Volatility mightbe less but spreads would be wider due to thehigher cost of ticket processing.

What would the NYSE look like stripped of themyth of accommodating the individual investor?

Most of the time, not much different. In timesof rapid movement, however, the weakness ofrelying on specialists' individually accumulated

capital would be glaringly apparent. Mecha-nisms would evolve to draw together the nowscattered sources

of liquidity. That alone wouldsignifican'vi:':

:::l _ . :::cap ac*v

(c)1988, PLEXUS GROUPA General Partnership

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