Quoting obligations aimed at improving prices in equity markets take effect today as part of regulators’ attempt to prevent a repeat of the May 6 crash.
The rules require market makers to submit bids and offers within 8 percent of the prevailing price for the biggest U.S. stocks. They ban stub quotes, or placeholder requests that range from pennies to thousands of dollars that were adopted in response to rules requiring traders to maintain bids and offers. Stub quotes resulted in a “significant proportion” of the almost 20,800 trades voided on May 6 when $862 billion in equity value was briefly erased in 20 minutes, regulators said.
“The rules will lead to the removal of stub quotes and the black eye stub quotes were on May 6,” said Chris Isaacson, chief operating officer of Bats Global Markets, the Kansas City, Missouri-based exchange operator that accounted for 10.2 percent of U.S. stock volume last month. “They were an anachronism. This is a good change for the market.”
Stub quotes were first employed on Archipelago Exchange in 2002 when the venue joined the Intermarket Trading System, which operated an order-routing network linking exchanges. ITS required markets to submit two-sided quotes, or both bids and offers, according to Jamie Selway, a managing director at Investment Technology Group Inc. in New York and the chief economist at ArcaEx at the time. The venue began operating as a so-called electronic communication network in 1997.
“Stub quotes were an artifact of old regulation,” Selway said. “They were never meant to trade.” The new rules will also establish a buffer of liquidity that will “eliminate the clearly erroneous trades that trigger trading halts,” he said, referring to the circuit breakers introduced in June for Standard & Poor’s 500 Index companies and later expanded to the Russell 1000 Index and more than 300 exchange-traded funds.
ITS was disbanded in 2007 when the Securities and Exchange Commission revamped equities trading and forced the New York Stock Exchange to become faster and more automated. NYSE bought Archipelago Holdings Inc. in 2006 in a deal that made the 214-year-old Big Board a publicly traded company. It became NYSE Euronext in a merger completed in 2007.
As trading in the first half of the last decade moved away from dealer markets and toward what’s known as limit-order books, in which liquidity comes from brokers and their customers, some market makers that had two-sided quoting requirements began widening their spreads, or the difference between the bids and offers they submitted to exchanges, Selway said. Stub quotes eliminated the need to repeatedly update one side of the quote and made the job easier, Selway said.
The new rules probably won’t increase liquidity at the best prices in the market, Isaacson said. By requiring quotes that guarantee liquidity, they will avoid the problem of voided trades that occurred on May 6, he said.
NYSE was the sole venue that didn’t cancel trades that day. Designated market makers and curbs that operated only on that exchange prevented share prices from plunging on NYSE, often by pausing trading in stocks for a few seconds or minutes.
For securities subject to single-stock circuit breakers, market makers will now have to place buy orders within 8 percent of the national best bid and place sell requests no higher than 8 percent of the national best offer between 9:45 a.m. and 3:35 p.m. New York time.
For the first 15 minutes and last 25 minutes of the trading day, market makers must quote within 20 percent of the national best bid or offer, or NBBO. If a stock isn’t in the program of trading curbs, firms must quote within 30 percent of the NBBO. The safeguards halt trading for five minutes if a security moves 10 percent within a five-minute period.
“It’s not a big stretch for us to add 100 shares on either side of the market for the vast majority of issues,” said Jamil Nazarali, a senior managing director and head of electronic trading at a market-making subsidiary of Knight Capital Group Inc. “Where it may be an issue is for those firms that don’t do a lot of trading, calling themselves market makers and hanging out with a very wide quote. They’ll have to decide whether they want to be market makers.”
Nasdaq OMX Group Inc.’s main exchange had 136 market makers in October, the most of any venue though down from 143 a year ago and 429 in 2000, according to the company. The number decreased annually in all but one year this decade as some firms merged or dropped out of an increasingly competitive business.
Market makers on venues such as Nasdaq and Bats will be able to use exchange systems to automatically update their quotes to ensure they comply with the new requirements while limiting the risks as prices move. The exchanges will update bids and offers so they’re within set ranges of the NBBO. While NYSE Arca ended its program that facilitated bids at 1 cent and sell orders at twice the stock’s last closing price, it’s developing a system that allows firms to automatically quote a certain percentage away from the NBBO, according to a notice.
The quoting requirements could pose risks for some firms in less-liquid stocks, said Nazarali, who’s based in Jersey City, New Jersey. For those shares, the spread between the national best bid and offer may be more than 60 percent of the share price, he said. To comply with the new rules, market makers will have to quote within that range, forcing them to buy at higher prices or sell for less than they would prefer, he said.
“It’s going to force a lot of people who want to be market makers to post much tighter quotes,” Nazarali said.