Change is brewing again at the New York Stock Exchange. Last Friday, the exchange proposed rules that would eliminate the traditional function of a specialist and replace them with designated market makers or DMMs. Is this a good move? How will it impact the Hybrid Market?

While the new DMMs will retain their role as the primary liquidity providers, they will give up some of their privileges in exchange for more freedom to trade other securities such as derivatives, according to published reports. Overall the changes are designed to move the exchange’s market structure forward and enable the DMMs to be more competitive, states the NYSE in its filing.

“They’ve changed the actual fundamentals of the specialist role in the marketplace,” says Miranda Mizen, senior consultant at TABB Group. “It’s a welcome move to provide proactive liquidity whether it’s in the form of dark or light liquidity,” says Mizen.

One key change is that specialists will no longer have a first look at electronic orders before they are publicly displayed. “Specialist algorithms will no longer get an exclusive, advance look at incoming orders,” according to Ray Pellechia who writes the NYSE”s Exchange Blog.

One of the keys to the new market model is technology. The exchange is upgrading “its Display Book to incorporate the majority of execution logic and to assume primary responsibility for tracking liquidity available at each specified price point,” according to the filing. With the new market model DMMs will make a pre-determined liquidity available on the Display Book based on a capital commitment schedule or CCS. This is designed to speed up executions and cut back on the amount of trade messaging causing latency in the exchange’s system. “Now you (the DMMs) will need to put your liquidity up so that when an order come in it will match against liquidity that is already there which makes for a more proactive environment,” says Mizen.

At the same time, the exchange is removing some aspects of the specialist function that are no longer relevant. “The removal of things like the negative obligation is a major change,” notes Mizen.
Under the existing rules, there are times that specialists couldn’t trade for their dealer account. Under the new plan, DMMs can trade competitively as dealers.

But what does this change mean for the Hybrid Market? Some media outlets are reporting that the new rules could spell the end for the Hybrid Market, which the NYSE launched in 2006 as a way to comply with Regulation NMS.

Specialists were at the center of the floor-based auction model that provided the opportunity for price improvement. But in the past few years, specialist firms have either left the exchange or reduced their staffs because they didn’t have the profitability they once had.

As the filing discusses, specialists have become less influential in the overall equation as they no longer control all the trading activity in their listed stocks. In a fragmented market, they are competing with upstairs market makers, OTC dealers, crossing networks and dark pools. By phasing out the specialist system and adopting a DMM structure with more flexibility, the exchange is making it more liquidity providers. At the same time, the exchange says its providing new tools to floor-brokers and off-floor participants.

As a sign of that, it unveiled the concept of a Secure Financial Transactions Infrastructure (SFTI) Community Trading Platform, a hosted trading technology service, last week and signed up UNX, an institutional agency broker, to provide its smart order routing and algorithmic trading strategies to floor brokers who can for the first time trade away from the exchange. And SFTI connected its first dark liquidity pool, Credit Suisse Advanced Execution Services Crossfinder, offering participants access to alternative trading systems.

In addition, I hear the exchange is going into a pilot in July to allow upstairs traders to post dark liquidity, something they were not able to do. On the other hand, there are still plenty of skeptics, saying these changes have taken too long and that specialists had a first look at the order flow for so long. With the NYSE announcing so many innovative initiatives in such a short period of time to attract liquidity and overhaul its technology, it's certainly a market on the move. While it's hard to turn around a 216-year old institution on the fly, this one is certainly trying.