Missing: The Stock Exchange Buyers of Last Resort

The U.S. Securities and Exchange Commission spent the last 15 years trying to encourage more competition among stock exchanges. It succeeded. Trading that used to be concentrated on the New York Stock Exchange (NYX) and Nasdaq today takes place on 11 exchanges. While this decentralized approach has lowered costs for investors, it virtually eliminated the traditional market makers who were obliged to buy and sell stocks when no one else would. Now the SEC is concerned the revolution went too far, leaving markets vulnerable when selling starts to snowball.

Chairman Mary Schapiro called on the agency in early September to examine whether the loss of "old specialist obligations" has hurt investors. With market making on most exchanges dominated by computerized trading firms that have few rules for when they must buy and sell, she said the SEC will consider ways to keep them from abandoning the market at the first sign of trouble. "In the old days, the specialist obligation was quite stringent," says Patrick Healy, a former trading executive at Bear Stearns who runs Chevy Chase (Md.)-based Issuer Advisory Group. "If he didn't meet it, he got canned....In the move to electronic trading, NYSE and Nasdaq emphasized speed, more technology, and less of a role for humans." John Heine, a spokesman for the SEC, declined to comment.

The debate over volatility gained urgency after May 6, when a sudden drop erased $862 billion in value in 20 minutes before the market recovered. Lawmakers have asked if the high-frequency-trading firms that have supplanted market makers destabilized the system by stepping away when they were needed most. "The players in our markets have changed, but our regulations have not kept pace," Senator Charles E. Schumer (D-N.Y.) wrote in a letter to Schapiro last month. "High-frequency traders pulled out during the free fall, leaving a dearth of liquidity and exacerbating market volatility." A report on the causes of the May 6 plunge from the SEC and the Commodity Futures Trading Commission is expected soon.

Vanguard Group, the biggest U.S. manager of stock and bond mutual funds, told the SEC in April that regulatory changes and pricing efficiencies produced by high-frequency-trading firms reduced costs for long-term investors by about half a percentage point over the past decade. A mutual fund returning 9 percent annually whose entire stockholdings are sold and replaced within a year would see the gain cut to 8 percent without the savings, according to Vanguard, which oversees about $1.4 trillion.

Exchanges historically relied on specialists, or securities professionals who made markets in designated stocks and provided prices through their willingness to buy and sell shares. Specialists who stood amid traders on the NYSE floor were charged with maintaining "fair and orderly" markets by stepping in when buyers and sellers weren't available. Nasdaq market makers performed similar roles over phones and computers, with as many as several dozen handling action in any given stock.

Specialists and market makers got something in return for serving as buyers of last resort: the ability to see supply and demand for stocks and profit from the difference between the bid and offer prices, typically 6.25 cents on actively traded stocks in the late 1990s. They suffered when exchanges started pricing stocks in 1 cents increments in 2001, squeezing profit out of the bid-ask spread.

In October 2008 the NYSE, which had lost market share to other exchanges, overhauled its rules to compete more effectively. To allow specialists to provide better prices for investors, it lifted some trading restrictions and reduced their responsibilities. While the specialists, now called designated market makers, retained heftier obligations than market makers at most other venues, they didn't have to be the traders of last resort when the market turned volatile. They also lost some benefits: They no longer got a look at all orders, which had helped them gauge supply and demand in their stocks.

Nasdaq gradually eroded the market makers' obligations as the spread between bid and ask prices decreased. In 2007 it eliminated the 20-year-old requirement that market makers provide quotes that are "reasonably related" to the prevailing price. The thinking was that electronic trading firms pursuing different strategies would end up providing bid and offer prices for stocks through changing market conditions.

The SEC is in the "early stages of thinking about whether obligations on market makers akin to what used to exist might make sense," Schapiro told reporters on Sept. 7. The issue 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," she said during a speech that day to the Economic Club of New York. The commission has introduced circuit breakers that pause trading in more than 1,300 securities if their price moves 10 percent in five minutes. One goal is to slow down trading when prices gyrate so investors can assess their reasons for buying and selling. It is also banning market makers from submitting quotes at unrealistically low prices, such as 1 cents, so prices won't plunge when buyers temporarily disappear.

The old system wasn't flawless. The Brady Commission Report on the October 1987 crash, when the Dow Jones industrial average fell 23 percent, found NYSE specialists and Nasdaq market makers didn't stem the downward slide of prices. Many Nasdaq market makers didn't answer their phones, ignoring customers, while overwhelmed NYSE specialists who had bought as sell orders flooded in later gave up or halted trading. It's not clear that any specialists or market makers can withstand a tsunami of selling. William O'Brien, chief executive officer of exchange operator Direct Edge, says once a rout has started, no trader will obey a regulation that forces him out of business. "If you burden any firm—I don't care how big or fast your computers are—if you have to buy when everyone is selling until you're bankrupt, even the biggest, fastest trading firm is not going to want to take on that obligation."

The bottom line: While increased competition in stock trading has lowered costs, it may have made the markets more vulnerable to rapid price moves.

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