The Changing Market – Finding Market Makers

With the dramatic changes in the market over the last three years, a key piece of our work is working with clients to identify and target market makers. The following article is adapted from TradersMagazine.com for the purpose of examining why the changes have occurred and where the direction is moving for market makers.

November 2010 - Once upon a time, market makers ruled the roost. From their cavernous trading rooms in New York City, Long Island and New Jersey, they controlled trading in Nasdaq securities. From the floor of the New York Stock Exchange, they ran the auctions. Spreads were wide and profits were fat. Times were good.

Then, suddenly, everything began to fall apart. Decimalization sliced spreads over 80 percent to a penny in the most actively traded stocks. The Order Handling Rules forced market makers to display customer limit orders, bringing in competition. Regulation ATS led to the creation of ECNs, which brought in more competitors. Regulation NMS decimated the NYSE's market share of the NYSE, eliminating the specialists' information advantage, and their volume.

In the past 10 years the number of market makers registered with Nasdaq has fallen by two-thirds, dropping from around 500 to 170. Limit-order traders have surged into a market largely based on time priority, further marginalizing the dealers. NYSE specialists have either dropped out or agreed to a special stipend from the exchange to stay in the game.

But now market makers are back in vogue.

Flash Crash - The May "flash crash" of 2010 prompted and outcry from regulators, politicians and industry figures that the market is lacking support from dedicated market makers. Because bids virtually disappeared during a four-minute period on May 6, the market toppled. From about 1120 at 2:41 p.m., the S&P 500 Index dropped to 1065 at 2:45 p.m., a fall of about 5 percent on heavy volume.

High-frequency traders, who now contribute between 40 to 50 percent of bids and offers in the market, were accused of desertion. The hyper-fast traders were already under scrutiny for their allegedly pernicious influence in the market, and May 6 only increased the suspicion that they were parasites up to no good. Regulators, politicians and industry executives are calling for the HFTs to assume stiffer quoting obligations and possibly be registered as market makers.

Bona fide market makers have not escaped criticism either. Because hundreds of sell orders on May 6 executed against so-called "stub quotes," or impossibly low bids posted by dealers, regulators and exchanges quickly proposed minimum quoting requirements. Some have called for even tighter requirements.
All in all, the marketplace, having once largely cast aside market makers as a hindrance to efficiency, is now actively embracing them. There is a sense that bona fide market makers--with obligations to provide two-sided quotes at prices as close to the top of the book as possible--are necessary and should once again assume a place of importance in the fabric of the market.

The Securities and Exchange Commission is certainly keen on the idea. In the wake of the flash crash, it pushed the exchanges to impose tougher quoting obligations on registered market makers and is mulling the imposition of market-maker obligations on HFTs.

SEC chairman Mary Schapiro told members of the Economic Club of New York in September 2010 that it might not be a bad idea for HFTs to assume both positive and negative obligations akin to those of the NYSE specialists of yesteryear. "The issue," she said, "is whether the firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times." Schapiro wondered where the HFTs were on May 6 when the bids dried up and, conversely, whether they should have been allowed to sell into that declining market.

Pressure on the SEC to impose obligations on HFTs is coming from both Washington and the industry. In August 2010, both Sen. Chuck Schumer, (D-N.Y.), and Sen. Ted Kaufman (D-Del.), penned letters to the SEC urging it to both register HFTs as market makers and require all market makers to quote more aggressively. Outgoing Sen. Kaufman directed the SEC to impose both affirmative and negative obligations on HFTs. While acknowledging their limitations in propping up a rapidly falling stock, Kaufman believes "such rules could restore a much-needed sense of stability to the marketplace and serve the trading interests of long-term investors."

From the industry, Thomas Peterffy, Chairman and CEO at Interactive Brokers Group, which operates the Timber Hill market-making unit, believes HFTs should be encouraged to register as market makers. In return, they (and all market makers) would have special privileges, in particular a speed advantage over non-market makers.

Recommendations are coming from others in the market making community as well. In July 2010, wholesalers Knight Capital Group and Getco banded with high-frequency shop Virtu Financial, all registered market makers, to urge the SEC to update the rules surrounding bona fide market makers. The trio wants the SEC to beef up the definition of a market maker and to impose tougher quoting obligations on registered market makers. That would include quoting at the national best bid and offer for a certain percentage of the day and maintaining certain size and depth parameters.

While acknowledging that such reforms would not have halted a May 6-type slide, the trio stated that the proposals would "make our markets better and more resilient, particularly in times of high volatility and price dislocation." All three firms are registered as market makers at NYSE Classic and NYSE Arca, where they meet quoting obligations similar to what they are proposing.

All of the hubbub begs a number of questions:

• Is it really necessary for the public markets to be supported by dedicated market makers?
• Should registered market makers be required to quote at the NBBO and provide minimum size and depth?
• If so, should they be given benefits unavailable to other market participants? 
• And what of the exchanges themselves? 
• Do they really want to impose obligations on HFTs and market makers? 
• Would they want to bear the inevitable costs associated with greater market maker support?
• Isn't the existing "flat" model in use by most exchanges good enough? 
• What about the HFTs? They are currently providing up to half the liquidity in the market. Should they be asked to do more? 
• What about the registered market makers? Their main business is to make markets for their customers, not the public markets. Should they be asked to do more for the exchanges? 
• And, finally, what exactly is a "market maker?"

Under SEC rules, there are two types of market makers: exchange market makers and over-the-counter market makers. Rule 600 of Regulation NMS defines an exchange market maker as "any member of a national securities exchange that is registered as a specialist or market maker pursuant to the rules of such exchange."

In other words, the SEC has punted regulation of market makers to the exchanges. While that may have made sense when the NYSE was the primary stock exchange in the U.S., it may not in a world where liquidity is fragmented over a dozen exchanges. Only one exchange--the NYSE--has a robust market maker program with affirmative, if not negative, obligations.