SEC Effectively Prohibits Stub Quotes

In another outgrowth of the May 6 Flash Crash, the Securities and Exchange Commission Monday approved rules that would effectively prohibit "stub quotes" in the U.S. equity markets.

Prices of "terrific U.S. stocks" as SEC chairman Mary Schapiro had put it earlier in the day at the Securities Industry and Financial Markets Association annual meeting in New York fell to a penny that day, for brief times, when demand for stocks essentially evaporated. All that was left were "stub quotes'' that brokers put in without actual expectation that they'd be fulfilled.

A stub quote is an offer to buy or sell a stock at a price so far away from the prevailing market that it is not intended to be executed, such as an order to buy at a penny or an offer to sell at $100,000.

A market maker, the SEC said, may enter stub quotes to nominally comply with its obligation to maintain a two-sided quotation at those times when it does not wish to actively provide liquidity.

Executions against stub quotes represented a significant proportion of the trades that were executed at extreme prices on May 6, and subsequently broken.

"By prohibiting stub quotes, we are reducing the risk that trades will be executed at irrational prices, and then need to be broken, if the markets become volatile," said Schapiro. "While we continue to look at other potential obligations for market participants, this is an important step in our effort to improve the functioning of the U.S. markets, and restore investor confidence following the events of May 6."

Market makers in exchange-listed equities will instead be required to maintain continuous two-sided quotations during regular market hours that are within a certain percentage band of the national best bid and offer.

The band would vary based on different criteria:

• For securities subject to the circuit breaker pilot program approved this past summer, market makers must enter quotes that are not more than 8% away from the NBBO.

• For the periods near the opening and closing where the circuit breakers are not applicable, that is before 9:45 a.m. and after 3:35 p.m., market makers in these securities must enter quotes no further than 20% away from the NBBO.

• For exchange-listed equities that are not included in the circuit breaker pilot program, market makers must enter quotes that are no more than 30% away from the NBBO.

• In each of these cases, a market maker's quote will be allowed to "drift" an additional 1.5% away from the NBBO before a new quote within the applicable band must be entered.

The new market maker quoting requirements will become effective on Dec. 6, 2010.