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November 1, 2010

Cover Story: In Search of Market Makers

By Peter Chapman and James Ramage

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SEC chairman Mary Schapiro told members of the Economic Club of New York in September 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, 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 chief executive 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, 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.

SEC Chairman Mary Schapiro

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.