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October 1, 2010

Exchanges Move to Kill 'Stub' Quotes

By Peter Chapman

Three of the largest exchange operators sent proposals to the Securities and Exchange Commission last month that would impose stringent new two-sided quoting obligations on market makers, ending the use of "stub quotes."

Brian Hyndman

Nasdaq OMX, NYSE Euronext and BATS Exchange all put out the same proposal: market makers will be required to maintain both a bid and an offer no more than a certain percentage away from the national best bid or offer, continuously throughout the day.

For stocks with an associated circuit breaker, that number is 8 percent. That's within the parameters of the new single stock circuit breaker, which triggers a trading halt once a stock rise or falls by 10 percent from "fair value."

For stocks without an associated circuit breaker, dealers will have to keep their quotes within 32 percent of the NBBO.

Currently all the stocks in the Russell 1000 have an associated circuit breaker as well as several exchange-traded securities. Eventually, circuit breakers are expected to be expanded to all 8,000 National Market System securities.

The move to tighten up the quoting rules was mandated by the SEC in the wake of the May 6 "flash crash," which saw thousands of trades execute at quotes below a nickel-so-called stub quotes.

"Stub quotes gave the industry a black eye," Brian Hyndman, a Nasdaq senior vice president in charge of U.S. transaction services, said. "This will be the minimum standard across all exchanges."

On May 6, over 7,000 trades were executed at prices below five cents. Most of these trades occurred on Nasdaq, NYSE Arca and BATS Exchange. All were later broken.

Of the five major exchanges, Nasdaq, Arca and BATS permit broker-dealers to register as market makers and quote with one-cent bids and extremely high offers, or stub quotes. NYSE has market makers, but no stub quotes. Direct Edge has no market makers.

Stub quotes allow dealers to be aggressive on only one side of the market or neither side if they choose.

According to Hyndman, due to market maker pushback, Nasdaq chose not to impose the more onerous quoting obligations championed by some players in the industry and Washington. A trio of market makers, for instance, campaigned for rules that would require dealers to quote at the inside between 5 percent and 10 percent of the day.

That was a non-starter according to Hyndman, who said that market makers felt the benefits they received were not commensurate with the responsibilities of quoting at the inside that often.

At least one veteran trading executive believes the proposals are a move in the right direction. Jim Deasy, a 30-year veteran now in charge of trading at Denver's Wedge Partners, calls the requirement a "great thing." It will weed out firms that call themselves market makers, but aren't really making markets, he notes. "They are 20 percent, 30 percent, 40 percent away from the market," Deasy said. "They add more confusion than anything else. They're not adding any liquidity. They're not representing any client orders. All they're trying to do is game the system."



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