The nation’s stock exchanges are preparing to propose rules that require market makers to post "reasonably priced" two-sided quotes for a certain percentage of the day.
The rules, if approved by the Securities and Exchange Commission and the Financial Industry Regulatory Authority, would bar exchange-registered dealers from fulfilling their obligations by posting prices that are far removed from the national best bid and offer. These so-called stub quotes have been in use for years and are partly to blame for the Flash Crash of May 6.
On that day, more than 20,700 trades were broken between 2:20 p.m. and 3 p.m., according to a joint SEC-Commodity Futures Trading Commission preliminary report on May 6. Most of those broken trades-roughly 16,100 of them-occurred between 2:45 p.m. and 2:55 p.m. And of those, almost 7,000 trades in more than 200 securities were broken because they had executed against stub quotes after liquidity had vanished.
The SEC is driving the agenda, hoping to ensure that investors never trade at unrealistic prices again as some did on May 6. Trades on that day for Accenture, for example, were executed at a penny. Until then, the stock had been trading just above $40. Stub bids are often set as low as 1 cent, while stub offers can be set as high as $2,000.
Market makers have quoting obligations. The SEC has rules for them, as do nine of the 10 equities exchanges. At a minimum, market makers must post two-sided quotes. Some exchanges do not require NBBO-related quotes. Some exchanges, such as the Chicago Stock Exchange, the New York Stock Exchange and NYSE Amex Options, do.
Nasdaq OMX adopted "reasonable width" quoting obligations in 1987, and, with SEC approval, eliminated them 20 years later. At the time, the SEC reasoned that Nasdaq’s proposed rules for market makers were similar to NYSE Arca’s and the SEC’s own. That means that market makers had to make two-sided markets and quotes didn’t have to be "reasonably related" to the NBBO.
The task of the SEC and the nation’s self-regulatory organizations is not a simple one. Still, the regulator and exchanges are busy debating the possible new obligations market makers would undertake, and incentives they would receive, to maintain fair and orderly markets.
But deciding how to replace stub quotes could lead to disagreements among regulators, exchanges and market participants about market makers’ obligations and incentives. While all parties agree that stub quotes should be abolished, some argue that more stringent obligations should be imposed on market makers without granting new incentives. Others counter that issuing more requirements without also granting new benefits would discourage market makers from providing liquidity.
Current benefits to market makers wouldn’t be sufficient compensation for the risks of undertaking new and onerous quoting obligations, said Chris Isaacson, chief operating officer of BATS Exchange, an exchange that allows stub quotes. "With market making, if you’re going to introduce tighter obligations there have to be commensurate rewards given, as well," he said. "Otherwise, fewer firms will be inclined to provide liquidity from market making, or there will be fewer market makers."
Market makers have used stub quotes to meet a requirement to provide continuous two-sided quotes at exchanges such as Nasdaq and BATS. But they’re usually submitted at such low or high prices-quotes to buy at a penny or sell at $2,000-that they’re never actually intended to be executed. That changed on May 6.
The SEC and exchanges have been discussing new market-maker requirements that include three general criteria, said Leonard Amoruso, general counsel for Knight Capital Group. Without giving specifics, Amoruso said the SEC is leaning toward requiring market makers to be at the national best bid or offer for a certain percentage of the trading day.
Second, the SEC would require bands–or designated spread widths–placed around market makers’ quotes. These bands would fall into the general price range employed by the SEC’s new circuit breaker, industry pros suggested, which pauses trading in certain stocks if the price moves 10 percent or more, up or down, in a five-minute period.
Finally, they are considering a minimum depth requirement, Amoruso said, obligating the market maker to quote at more than one level.
Market maker benefits have gradually eroded over time as some have been regulated out of existence, Amoruso said. The elimination of the exemption to the short sale tick test is one example. In another, market makers used to be entitled to the entire spread. But ever since regulators extended the trade-ahead, or Manning, rule to market orders, they’re getting less of it.
Some strong incentives remain. Currently, market maker benefits for quoting at Nasdaq and BATS include short selling, locate exception, T+6 days on fails, margin, internalizing orders and the ability to trade for one’s own account. Nasdaq feels those benefits are sufficient for market makers, should the SEC and the exchanges agree to adopt new quoting requirements near the circuit-breaker bands, said Brian Hyndman, a senior vice president for Nasdaq OMX. But they’re not enough if market makers are also required to be at the NBBO at least 10 percent of the trading day, he added.
"If we made the requirement that you had to be driving at the inside 10 percent or 20 percent of the day, then that becomes a lot more difficult for the market maker," Hyndman said. "And they might need additional benefits from the SEC, or from the individual SROs."
Getco disagreed. Stephen Schuler and Daniel Tierney, co-founders of the high-frequency trading firm and NYSE designated market maker, wrote in a Financial Times op-ed piece that market makers should be at the NBBO for at least 10 percent of the trading day. They should also be required to quote within the circuit breaker price band a minimum amount of time. Doing both would provide useful liquidity and relevant prices for investors, they wrote.
"There needs to be greater clarity around what it means to be a market maker," the firm said through a spokesman. "We think the best way to define what it means to be a market maker is by strengthening the obligations that they must fulfill in order to qualify for the benefits they already have."
Later, in a joint letter to the SEC, Getco, Knight and the proprietary trading firm Virtu Financial wrote that that market makers should be at the NBBO for at least 5 percent of the trading day.
Knight makes markets in every National Market System security, numbering around 6,000 in all, Amoruso said. The firm agrees that market makers must have tighter obligations. But they should also be rewarded more for any new risk they’ll be forced to shoulder, he added.
"If you require market makers to have a maximum quoted spread so that they can only be a certain percentage rate away from the inside, you are asking them to take on additional risk and liability," Amoruso said. "It’s hard to have that conversation without having a parallel conversation related to benefits."
What does he have in mind? For further incentives, Amoruso suggested a possible expansion of some of the exemptions under Regulation SHO. For example, in less-liquid names, there could be longer periods of time to close out sales for market makers, he said. Or, there could be a reduction in market access fees for market makers who help facilitate customer order flow.
Whatever is decided, a proposal should materialize soon, said Joe Mecane, an executive vice president at the New York Stock Exchange. "It won’t be in a couple of months," he said, "but in a couple of weeks, in terms of getting something out there."
