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November 1, 2010

Cover Story: In Search of Market Makers

By Peter Chapman and James Ramage

Even tightening obligations on registered market makers beyond the proposed 8 percent collar is fraught with potential problems. Because exchanges would have to pair benefits with the obligations, the result would be a two-tiered market, some argue, making it difficult for newcomers to enter the business. "Since there appears to be broad agreement that increased obligations would not prevent market failures, this cost is simply not justified," Quantlab and three other HFTs wrote the SEC in September.

 

Naked Shorting

The two benefits often cited as justifying the obligations of market making both relate to "naked" short selling, whereby the short seller doesn't borrow the securities at the time of the sale. Under the SEC's Regulation SHO, market makers are exempt from the ban on naked shorting in two ways. First, they are exempt from rules requiring traders to, at a minimum, locate a stock, even if they haven't actually borrowed it. Market makers can take a little longer to locate the security.

Second, firms engaged in "bona fide market making" get six days--as opposed to the standard three days--to cover their short positions. Both benefits help market makers handling customer orders sell short to those customers in timely fashion without having to track down the security immediately. The exemptions are particularly useful when trading illiquid names.

Others say the primary benefit of being a market maker is to be able to internalize orders and rack up trading profits. This far outweighs any Reg SHO exemptions, sources say. In truth, it works the other way around: To make markets for customers, and handle their limit orders, brokerages must register as market makers. Either way, the two go hand in hand.

HFTs, for the most part, do not have customers. And while some HFT executives, including Concannon, say the Reg SHO exemptions make taking on market maker obligations worthwhile, most HFTs have not registered as market makers. A perusal of the ranks of Nasdaq's market makers turns up only five prop shops: Virtu, Hudson River, Jane Street, Assent and EWT.

Still, some contend almost any HFT could meet the current obligations. "It's not an incredibly high threshold," said Marty Mannion, chief operating officer with wholesaler Citadel Execution Services. However, if they are made more onerous "it could actually drive liquidity out of the marketplace," he added. "Certainly, if the SEC or other regulators impose much more stringent obligations on market makers, additional benefits would be needed to preserve liquidity."

Interestingly, the letter from Quantlab, et al, to the SEC does not ask the regulator to refrain from imposing market maker obligations on HFTs. It asks the regulator not to make existing market maker obligations more stringent. Does that imply they are resigned to their fate? At least one high-ranking Wall Street official is confident the SEC will impose obligations on HFTs. NYSE Euronext chief executive Duncan Niederauer, speaking in Washington last month at a conference sponsored by the National Association of Corporate Directors, said he expects new rules by January. The flash crash made plain that the structure of the market is too vulnerable and that some firms are reaping benefits while not contributing to market stability, Niederauer said.

 

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