U.S. Business: That Third Market

When Keith Funston goes to Washington, he is usually seeking less regulation of the nation’s securities markets, not more. Last week, testifying before the Securities and Exchange Commission, the president of the New York Stock Exchange urged tighter rules for a controversial sector of the business. He was aiming at the “third market” (the other two: the exchanges and the over-the-counter market, which deals in unlisted stocks), a sort of discount house that handles off-the-floor trading in stocks listed on the New York or American exchanges. Its more than $2 billion volume is still small compared with the regular exchanges (about 3% of the Big Board’s), but the third market is growing steadily—and has so far escaped nearly all the regulations imposed on the exchanges. Funston wants the SEC, which has been holding hearings on the third market, to compel it to play by roughly the same rules as the others.

Moving Large Blocks. The third market got started some years ago when such institutional investors as pension funds, insurance companies, mutual funds and banks were permitted by law to expand their holdings into common stocks. The bond houses that had been serving them gradually broadened their services to meet their customers’ new needs, thus forming the core of the new market. It is now dominated by seven firms, but the Big Three are Blyth & Co., First Boston Corp. and Weeden & Co., all in Manhattan. Actually, the exchanges and the third market are quite different. While they are public auction places for company shares, it operates through a series of private, negotiating transactions, publishes no price quotations and has no central authority.

The third market’s steadiest customers are still institutions and stockbrokers who are not members of an exchange. Because institutions usually buy and sell large blocks of stock, they use the third market to bypass the exchanges and thus move the big blocks without upsetting the market price. They also like the bargain rates. Most third market firms keep on hand an inventory of widely traded stocks (Weeden’s inventory of 210 listed stocks amounts to about $12 million), which they offer to customers at a flat price based on the exchanges’ last quotation plus a small fraction of a point—which nearly always amounts to less than a regular commission.

Closer Scrutiny. The New York Stock Exchange complains that such backdoor operations are unduly secretive and siphon off stocks that otherwise would be available to the general public. Unlike floor specialists, third market dealers are also under no restrictions against dumping inventories when the market is falling. The exchange is even more upset over the commissions its member firms are losing to the third market. If the exchange wanted to, however, it could check the third’s growth in one stroke: by offering commission discounts on large-volume transactions. Under the pressure of competition, the exchange has begun to review the possibility of doing just that.

Third market dealers insist that the competition they give the exchanges is healthy, and the SEC seems to agree. In its Special Stock Market Study Report last year, the SEC found that “the third market has been, on balance, beneficial to investors and the public interest.” Nonetheless, the Government has plans to bring the market under closer scrutiny—though not as close as the exchange would like. By year’s end, the SEC is expected to impose new rules requiring that third market firms identify the stocks in which they deal and make quarterly reports on all their off-board trading.