STOCK MARKET What role do specialists play?

Despite high-tech alternatives, specialists thrive as stock market go-betweens.
NEW YORK (AP) -- Michael LaBranche has endured plenty of gut-wrenching events on Wall Street, from the 1987 stock market crash that nearly buried his family's trading firm to the late 1990s tech boom that threatened to replace his human brokers with computers.
So it's no surprise that the chief executive of LaBranche & amp; Co., the specialist company his grandfather founded in 1924, won't admit to sleepless nights as the New York Stock Exchange mulls dramatic reforms.
"When you go through a period like now it always feels like it's the worst ever," acknowledges LaBranche, who began at the company years ago as a clerk delivering trade orders on the NYSE floor. "Then you look back and say, that was definitely manageable."
With regulators stepping up a probe into allegedly illegal activity by specialists, and the NYSE's structure likely to be altered, traders worry that the exchange's 211-year-old open-auction model might finally give way to more electronic trading.
If some critics have their way, the specialists, at the heart of the current system, would become extinct. But like the disfavored stocks they must buy and sell and somehow make a profit, specialists are betting they emerge as winners.
"The specialist business is going to succeed by providing the best prices," LaBranche said. "That's how specialists have to think going forward. If they understand that, they'll do fine."
A case in point
Jim Babbitt, 53, stands at his post on the crowded floor of the New York Stock Exchange on a recent, typical day. In general, stock prices are drifting upward.
Babbitt, who works for Fleet Specialist Inc., handles shares of General Electric. Like other specialists, he is the sole representative on the floor for the stock: To buy or sell GE, traders must go to Babbitt.
Some specialists handle several stocks; some handle just a few or even just one if it's widely held and traded a lot -- like GE.
At the market's open, a broker tells Babbitt his client wants to buy 10,000 shares of GE at $30. No seller is willing at that moment. It's likely they, like Babbitt, believe the stock will move higher. Still, Babbitt steps in and sells the broker 7,000 shares from his firm's account.
Babbitt's sale reflects his specialists' duty to not only match buyers and sellers but also to keep a stock fluid by trading from their own accounts when no one else wants to. The idea is to ensure "a fair and orderly market" with fewer price swings; investors also benefit from the "price improvement."
For their public service, specialists are given access to a "display book" -- a computer screen that shows every buy and sell order, giving a good picture of a stock's demand. Specialists use this information to help "auction" shares to themselves and floor brokers.
Babbitt's decision to unload 7,000 shares is a hedge -- it keeps the buyer happy while giving him room to sell more later if prices move up. This time Fleet gains anyway: Babbitt is selling from a reserve of GE shares bought at about $28 on a bet prices would rise.
Crashes
Specialists aren't always so lucky. In the October 1987 crash, specialists were forced to buy more than $700 million in stocks and to go home that evening wondering how they would pay for their positions.
To keep firms afloat then, NYSE chairman John Phelan and executive vice president Dick Grasso eventually secured help from the New York Federal Reserve. Still, the number of specialist firms handling the NYSE's 2,800 stocks have shrunk from more than 50 at the time to now just seven, due in part to the huge capital required.
"With each trade you have to make everyone happy -- the buyers and sellers who want the best deal; [regulators at] the exchange, because they don't want to be in embarrassing situations ... and management, because they like to make money," Babbitt said. "You do the best you can."
In the end, the specialist firms usually come out ahead -- even when most investors don't.
Profits
During the bear market, NYSE specialist firms reported after-tax profits of $397 million on revenue of $1.65 billion in 2002, compared with $414 million on revenue of $1.78 billion in 2001. In good years, individual specialists can earn more than $1 million.
Pension and mutual funds say they have no choice than to trade at the NYSE since few buyers and sellers go elsewhere. Despite the promise of speed and fairness, electronic communications networks offered by Nasdaq, Instinet and Archipelago and which bypass the specialists have nowhere near NYSE's trading volume.
The NYSE says its execution of more than 80 percent of its listed companies' trades proves that customers are happy and prices are better; critics argue that federal regulations have historically made it difficult to compete with the NYSE, the nation's oldest exchange.
"A lot of our members have been frustrated with the NYSE system," said Sarah Teslik, executive director of the Council of Institutional Investors, which represents 130 pension funds. Her group is pressing interim NYSE chairman John Reed to revamp the open-auction system.