The stock market's wild swings in recent years have prompted regulators to consider new obligations on liquidity providers-traders that post constant streams of quotes, hopefully in bad times as well as good.
These providers, who now are typically classified as high-frequency traders, have emerged as modern-day market makers, buyers and sellers who ensure that transactions in a stock can be made at any time.
But unlike past market makers, they do not have to trade when markets come unhinged.
This was highlighted in the Flash Crash of May 6, when the Dow Jones Industrial Average dropped 300 points and then plummeted another 700 points before quickly recovering most of that loss. That day, many liquidity providers, who operate high-speed algorithmically driven trading strategies, turned off their machines. The result: Prices in some cases fell to a penny, with a lack of standing buy orders at higher prices.
Now regulators are considering ways to incentivize liquidity providers such as Getco, Citadel Investment Group and RGM Advisors to take on new-and at times risky-obligations. The incentives could include allowing cooperating firms to co-locate their servers in the same facilities as the matching engines of trading venues, getting direct-data-feed services they currently purchase from market centers and other providers, or mandating larger quote increments to generate wider profits in good times and make up for providing quotes during the bad. Obligations, meanwhile, could include posting longer-lasting quotes and stepping up participation in the market in volatile periods.
The Securities and Exchange Commission first issued a concept release on equity market structure January 14 that requested input on the role of liquidity providers in today's market.
Then on June 2,the SEC held a market-structure roundtable that highlighted concerns by traditional buy-side investors about some high-frequency trading strategies. And the regulator is likely to impose some type of new liquidity-providing obligations that would apply to high-frequency trading firms, according to executives at major exchanges communicating closely with SEC staff about the issue.
"It seems likely that changes will be made to the definition of what it means to be a market maker, possibly with some form of obligation imposed. The question is what form they'll take and how they'll be mandated," says Joseph Mecane, chief administrative officer for U.S. markets at NYSE Euronext.
In response to the May disruption, the SEC adopted the circuit breaker rule June 10 requiring exchanges to pause trading in individual stocks for five minutes if their prices move by 10% or more in a five-minute period. The pause gives market participants time to assess whether the drop was justified or a market glitch. The circuit breakers will apply to stocks in the Standard & Poor's 500 Index during a six-month pilot. Afterward, the pausing policy could be extended to all listed stocks.
Since then, the SEC has included exchange-traded funds and additional stocks in the program.
Some market participants say, however, that more fundamental measures are necessary, including the establishment of an alternative market for smaller-cap stocks designed to incent the creation of two-sided quotes in those names.
"We think we need an alternative, a dealer-driven market with fixed spreads and commissions that provides sufficient economics to support folks providing liquidity, research and sales support," says David Weild, senior capital markets advisor at Grant Thornton and a former vice chairman at Nasdaq.
The New York Stock Exchange and sister exchange NYSE Amex require their designated market makers, each assigned hundreds of stocks, to quote at the national best bid and offer 10% of the time for actively traded stocks and 15% of the time for other stocks. They also must increase their participation to volatile periods, which NYSE Euronext says they did during the Flash Crash.
In return, these market makers receive a higher rebate when their limit and marketable limit orders are executed, and when they tie other market participants at the best bid or offer they're allocated a greater portion of shares.
The registered market makers at other exchanges receive incentives available to all market makers, including lower capital requirements imposed by their clearers and an exemption from regulation SHO's requirement to locate a stock to borrow before shorting it. But they have no specified liquidity-providing obligations.
Weild chairs the Small Business Financing Crisis Task Force of the International Stock Exchange Executives Emeriti (ISEEE), which represents senior executives at 25 exchanges worldwide. He says the tight spreads in today's electronic markets have crippled smaller companies' ability to raise equity capital and attract aftermarket support, because market makers no longer derive sufficient revenue per trade to support the sort of handholding needed to sell shares of smaller companies.
He says the ISEEE doesn't aim to "jettison" current market structure. The group would rather add a new one: a market serving smaller stocks, with wider spreads that would give market makers the financial incentive to provide that support. He notes that NYSE specialists-before they were eliminated in summer 2008-were given a collection of large-cap and smaller-cap stocks whose orders they were permitted to view and act on before those orders hit the exchange.
"They were given a free peek at the book [of orders for large-cap stocks] from which they were allowed to make excess profits. But they were required to give something back, which was providing liquidity to small-cap companies," Weild says.