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November 1, 2010

Cover Story: In Search of Market Makers

By Peter Chapman and James Ramage

"There is no rule defining "bona fide market makers," Concannon said. "I want a federal rule that incorporates liquidity provision marketwide." The letter Concannon's firm submitted to the SEC in conjunction with Knight and Getco offers a "framework" of relatively specific obligations any future rule might incorporate.

Sen. Chuck Schumer (D-N.Y.)

Sen. Schumer's proposal for an update of SEC rules governing market makers is strikingly similar to the Getco-Knight-Virtu conception, but goes one step further. Schumer wants any rule to be worded so that it encompasses HFTs. "Many high-frequency traders are today's de facto market makers," Schumer told the SEC. "However, they are not subject to the legal obligations of market makers."

So what do the exchanges make of all this? NYSE Classic, which has a history of expecting more from its market makers, voted with its wallet two years ago, when it began its designated market maker (DMM) and supplemental liquidity provider (SLP) programs. To stabilize a declining market share and inject some stability into its stocks' prices, it agreed to provide better-than-average rebates to market makers to quote at the inside a given percentage of the day. The affirmative obligations at NYSE are now the most stringent among the major exchanges. According to data provided by NYSE, in September, designated market makers and supplemental liquidity providers participated in a startling 58 percent of all shares traded at NYSE Classic. Of those trades, the market makers were liquidity providers in 50 percent of all shares traded. (Interestingly, three HFT firms--Getco, Hudson River Trading and Tradebot Systems-are designated market makers at NYSE Classic.)

NYSE Arca operates a program similar to the NYSE's SLP program for trades in Arca-listed securities. These are mostly exchange-traded funds and account for only about a quarter of Arca's total volume. Market makers earn a rebate higher than that paid to others for quoting at the NBBO a certain percentage of the time.

Yet while NYSE believes in market maker support, it is hesitant to recommend that non-registered HFTs be required to assume market maker obligations. "If someone is just a very large part of the market or doing a lot of trading, but is not necessarily getting any of the benefits of a market maker, then they should not be required to register as a market maker," said Joe Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext.


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