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August 1, 2010

Stub Quotes Under Fire

By James Ramage

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Stub quotes are on the way out. 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 and 3 p.m., according to a joint SEC-Commodity Futures Trading Commission preliminary report examining May 6. Most of those broken trades--roughly 16,100 of them--occurred between 2:45 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 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 two decades 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."