Cover Story: In Search of Market Makers

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

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.

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.

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.

All of the hubbub begs a number of questions. Is it really necessary for the public markets to be supported by dedicated market makers? Should registered market makers be required to quote at the NBBO and provide minimum size and depth? If so, should they be given benefits unavailable to other market participants? And what of the exchanges themselves? Do they really want to impose obligations on HFTs and market makers? Would they want to bear the inevitable costs associated with greater market maker support? Isn’t the existing "flat" model in use by most exchanges good enough? What about the HFTs? They are currently providing up to half the liquidity in the market. Should they be asked to do more? What about the registered market makers? Their main business is to make markets for their customers, not the public markets. Should they be asked to do more for the exchanges? And, finally, what exactly is a "market maker?"

In some jurisdictions, including those in Europe, any firm that exceeds a certain level of activity is required to register as a market maker and assume quoting obligations. That’s regardless of whether or not the firm is doing a customer business. In the U.S., by contrast, SEC rules only rope in firms trading on behalf of customers. So, while firms such as Merrill Lynch are required to register as "dealers" with the SEC, for doing a market making business, proprietary trading houses such as Renaissance Technologies are not.

Under SEC rules, there are two types of market makers: exchange market makers and over-the-counter market makers. Rule 600 of Regulation NMS defines an exchange market maker as "any member of a national securities exchange that is registered as a specialist or market maker pursuant to the rules of such exchange."

In other words, the SEC has punted regulation of market makers to the exchanges. While that may have made sense when the NYSE was the primary stock exchange in the U.S., it may not in a world where liquidity is fragmented over a dozen exchanges. Only one exchange–the NYSE–has a robust market maker program with affirmative, if not negative, obligations.


Federal Rule

Some would like to change this scenario. Chris Concannon, a partner at Virtu, and formerly a senior Nasdaq official, wants to see the SEC adopt universal rules governing market maker behavior. Concannon is not advocating the registration of HFTs as market makers, but does want to see the SEC pass a beefed-up rule covering existing market makers no matter where they trade.

"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. 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.


Nasdaq Statement

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."

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.

Others also question the need for market maker support of stock prices. They point to the ready availability of liquidity during stable times. They also note that registered market makers are unlikely to support a rapidly crashing market anyway.

At least one SEC commissioner is in this camp. Speaking at this year’s Security Traders Association conference, Troy Paredes said, "During periods of stability, the value of subjecting high-frequency traders to market maker obligations is not self-evident. In short, when liquidity already is forthcoming and equity markets are not stressed, one has to question what the benefit is of imposing obligations that are intended to bring forth liquidity."


Futures Markets

Others note that the world’s futures markets function just fine without market makers. One is Cameron Smith, general counsel with HFT firm Quantlab Financial, who opposes a return to the days of the centrality of market makers. "Look around the world at other markets–whether the futures markets in Europe or the Chicago Mercantile Exchange–none of those markets have market makers," Smith noted at this year’s Traders Magazine conference. "They might for some of the less-liquid names, but not for all the liquid securities. All of those markets have a particularly high percentage of professional traders; plus, they all have circuit breakers or something that stops the markets from dropping precipitously."

Most trading houses Traders Magazine spoke with say that HFTs should not be forced to register. That includes Getco, which says it provides two-sided markets in about 3,000 stocks everyday. "The whole rule structure is designed to provide firms with a choice," said Getco general counsel John McCarthy. "If you want the obligations associated with being a market maker, you should also get any associated benefits. But it doesn’t make sense to require market participants to adhere to a set of obligations if they don’t want to do so, even if they trade in a manner that looks like market making."

It’s not clear that it would even be possible for the SEC to impose market making obligations on HFTs. One senior bulge bracket trading executive told Traders Magazine that the SEC and the exchanges can only mandate registration if the firm in question is running a pure market-making strategy.

It’s unlikely that anyone can provide a comprehensive enough definition of market making strategies to encapsulate what each HFT does, he said. "I don’t know if the SEC or the exchanges are going to be able to mandate that people [register as] market makers," he said. "Someone can be a lot of the volume, but not be a market maker."

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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