Specialists: The Designated Market Makers of Wall Street (Chapter 24)
The specialist system is one of those things that sounds simple on paper but gets really complicated in practice. And controversial. Very controversial.
Some exchanges assign special responsibilities to certain members called specialists. These traders must continuously quote two-sided markets (both a bid and an offer) so that someone is always willing to trade. They must keep prices orderly and prevent wild jumps. In exchange, they get privileges that other traders don’t have.
Chapter 24 is Larry Harris explaining exactly how this deal works, who benefits, who gets hurt, and why people fight about it.
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The Three Roles of a Specialist
Specialists wear three hats. They’re dealers when trading for their own accounts. They’re brokers when handling orders for other brokers. And they’re exchange officials responsible for conducting orderly markets.
Most NYSE specialists trade between three and six stocks each, usually one active stock and a few less active ones. By 2001, just eight firms employed all NYSE specialists, and five of them handled 95% of all NYSE dollar volume.
The specialist system supposedly originated when a man named Boyd broke his leg in 1875. Unable to walk the NYSE floor, he sat down and announced he’d trade only Western Union. Brokers appreciated always knowing where to find someone willing to trade that stock. The first specialty was born out of a broken leg and good customer service.
Affirmative Obligations: When You Must Trade
The primary obligation is simple in concept: you must ensure a reasonable market always exists. When nobody else is willing to trade, the specialist must step in. They must quote both a bid and an offer, and the spread between them can’t be too wide. They are the traders of last resort.
Exchanges also expect specialists to smooth prices. If uninformed traders demanding liquidity would cause a big price jump, the specialist should step in to cushion it. For example, if the limit order book has a gap between the best offer at 22.3 and the next offer at 22.7, a specialist might fill orders in that gap at 22.4, preventing a jarring price spike.
This obligation to create “price continuity” goes back to the days of telegraph ticker tapes when traders could only see last trade prices, not current quotes. They needed prices to move smoothly so they could tell if their orders got fair treatment.
But creating price continuity can be expensive. Sometimes nobody wants to trade because informed traders know something is changing. The specialist then trades on the losing side. They buy when prices are falling or sell when prices are rising. That’s costly. And the uncertainty is brutal: if the specialist lets prices drop quickly and they later rebound, people accuse them of failing to provide enough liquidity.
Negative Obligations: When You Cannot Trade
Specialists can’t just trade whenever they want. Exchange rules say they must yield to public orders at the same price or better. They can only trade with incoming marketable orders (market orders and marketable limit orders). They can’t trade ahead of public limit orders unless they offer a better price.
The “public liquidity preservation principle” also prevents specialists from filling limit orders on their books for their own accounts. Without this protection, a specialist could see good news about to hit, quickly fill a sell limit order sitting on the book at 50, and then watch the price rise to 55. The limit order trader would never have had time to cancel.
So specialists can only offer liquidity, and only when nobody else is offering it at the same or better price. These restrictions are the price they pay for their special privileges.
The Privileges: Where the Money Is
And the privileges are significant. Maybe the biggest one is information about order flows. Specialists see the entire system order flow as it arrives. They see the limit order book. They see what floor brokers are doing. They always have an information advantage because they see it first.
Speculative strategies. Specialists can use order flow information to forecast short-term price changes. They trade on the side their information favors and avoid offering liquidity on the losing side.
Quote-matching. When the book is heavy on the buy side, specialists know they’re protected from having to provide buy liquidity. They might buy in front of that book. If prices rise, they profit. If prices fall, the book’s buy orders absorb the selling before the specialist has to step in. Meanwhile, they can sell their position to any market buy orders that arrive.
Cream skimming. Specialists decide whether to trade after they see who’s sending the order. Small retail traders tend to be uninformed, so specialists improve prices for them more often. Large institutional orders might be informed, so specialists let those go to the book. This selective filling is extremely valuable because it lets specialists avoid the informed traders who would hurt them.
The stopped stock option. Specialists can “stop” an incoming order, guaranteeing it will execute at a certain price or better. While the order is stopped, the specialist creates a look-back timing option. They can exercise it (fill the order from their own account) whenever they want, or wait to see if someone else will take the other side. If the market moves in their favor, they exercise. If it moves against them, they wait and hope someone else shows up. This is free money from being able to decide after seeing what happened.
The market open. Specialists conduct the opening auction and can see all the orders before deciding how much to participate. The opening is often imbalanced, and prices frequently reverse after the open, so specialists who provide opening liquidity often profit.
The Ethics Get Murky
Harris tells a remarkable story about the SPDR (Spider) specialist on the American Stock Exchange. The specialist received a huge stop order to sell 500,000 shares if the price hit 100. The SPDR was trading around 100.50.
The specialist then aggressively sold S&P 500 futures in Chicago to push the market down. This caused other traders to sell SPDRs, clearing the buy orders above 100 from the book. The specialist was setting up to buy those 500,000 shares cheap and lock in a profit against his futures short.
But just before the trigger, a market maker in the crowd bid 100.0625 for 100,000 shares, trying to exploit the price discrepancy. The price recovered and the specialist lost on his futures position.
Was this ethical? It looks like the specialist was gunning the market to exploit his client’s stop order, which would violate his agency obligations. But his defense would be that he believed the market was dropping and sold futures to be able to give a better price on the stop order.
Who Benefits, Who Pays
The specialist system creates a real transfer of wealth. The beneficiaries are mostly small, uninformed market order traders who get price improvement. The people who pay are limit order traders, in front of whose orders the specialists step.
Small traders get better prices because specialists can selectively fill their orders (cream skimming). But limit order traders face reduced opportunities to trade profitably because the specialist takes the good trades and leaves them with the bad ones.
And the math changed when tick sizes got smaller. When the minimum price increment dropped from one-eighth to one-sixteenth of a dollar in 1997, and then to one penny in 2000, it became much cheaper for specialists to step in front of public orders. Specialist participation rates and profitability both increased substantially.
The Regulatory Balance
Regulators have to constantly balance the value of specialist privileges against the liquidity they provide. Exchanges squeeze specialists when they’re making too much money and public traders complain. Specialists threaten to quit. But they rarely do, and lots of traders want the job, suggesting exchanges probably aren’t squeezing hard enough.
The deeper problem is that the liquidity specialists provide is a public good. Everyone benefits from continuous markets, even traders at other exchanges. But specialists can only earn money from traders who trade with them. When other dealers compete away specialist profits during normal times, specialists might not have enough reserves to provide liquidity during volatile times when nobody else will.
Many people believe the whole system is fundamentally flawed. They argue regulators can never properly balance privileges and obligations, and that markets should switch to pure electronic order books with price-time priority. The rise of electronic proprietary traders using computers to submit and adjust orders was already chipping away at the specialist’s advantages when Harris wrote this.
The specialist system is a fascinating case study in market design: how do you get someone to provide a public good (liquidity) in a competitive market where everyone wants to free-ride?
Next: Internalization and Crossing
This post is part of a series retelling “Trading and Exchanges: Market Microstructure for Practitioners” by Larry Harris (Oxford University Press, 2003). The goal is to make these concepts accessible to everyone, not just finance professionals.