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November 1, 2010

Cover Story: In Search of Market Makers

By Peter Chapman and James Ramage

Despite its high level of market maker support, NYSE Classic still only accounts for about 20 percent of the volume traded in the public markets. The other 80 percent is largely divided between four exchanges--NYSE Arca, BATS Exchange, Direct Edge, and Nasdaq OMX. These exchanges operate very differently from NYSE Classic, having largely eschewed endowing one class of trader with special benefits in return for quoting obligations. They prefer a "flat" model.

BATS would not discuss the issue of registering HFTs as market makers. Direct Edge--which does not currently have market makers-is opposed to mandatory registration. "Proprietary trading firms should not be forced to register as market makers," said Bryan Harkins, the exchange's head of sales and strategy. "While Direct Edge supports the standardization of SRO market-maker obligations beyond today's stub quotes, any firm's decision to assume those obligations--whether high-frequency or low-frequency--should be voluntary."

Bryan Harkins, Direct Edge

Nasdaq, with the largest stable of market makers, made the following statement: "We operate our markets in an open access, fair and transparent manner, with our benefits and features available to all members. If HFT or other firms choose to accept market-maker benefits, they then also accept market-maker responsibilities. We are continually working to strengthen our markets by working with the regulator and other market participants to improve market-making in general and liquidity provision in general."

Nasdaq has already broached the issue of additional quoting obligations with its 170 market maker members. This summer Nasdaq had to inform them it was bringing back a rule it discarded three years ago requiring them to quote at prices "reasonably related to the market." The May 6 stub quote fiasco made that necessary. Nasdaq and the other exchanges have proposed requiring their market makers to keep their quotes within 8 percent of the NBBO in the most heavily traded securities. Getting market makers to accept anything more stringent would likely mean providing them with economic incentives, said Brian Hyndman, in charge of U.S. transaction services at Nasdaq. "But we're not there yet," he said.

Despite the May 6 flash crash, which many consider an isolated event, prevented from happening again by the new single stock circuit breakers, it is not clear that market maker support is necessary for the U.S. stock market. Four of the five major exchanges, accounting for nearly 80 percent of all exchange-traded volume have hummed along happily for years with the "flat" model. BATS only has five market makers. Arca has 14 for Tape "B" securities only. Direct Edge has none. Nasdaq has 170 but, like the other three exchanges, hasn't asked much of them. Nasdaq's apparent philosophy, based on its recent history, is of making its marketplace friendly to limit order traders, putting them on a par with market makers.