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November 1, 2010

Cover Story: In Search of Market Makers

Regulators and Industry Call On Liquidity Providers to Take On More Risk

By Peter Chapman and James Ramage

Once upon a time, market makers ruled the roost. From their cavernous trading rooms in New York 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.


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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" has prompted 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.