The SEC approved new rules proposed by the exchanges and FINRA to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” in the U.S. equity markets.
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 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.
The new rules address the problem of stub quotes by requiring market makers in exchange-listed equities to maintain continuous two-sided quotations during regular market hours that are within a certain percentage band of the national best bid and offer (NBBO). 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 December 6, 2010. Since May 6, the SEC has taken several steps to reduce the chance that the events of that day would happen again. Among other things, the SEC:
- approved the above-mentioned circuit breaker pilot program, in which trading would pause if a stock price moved more than 10% in five minutes. That program now applies to stocks in the S&P 500 or the Russell 1000, as well as certain exchange-traded products.
- approved new rules requiring the exchanges to clarify up-front how and when trades would be broken.
- proposed a new rule that would require the self regulatory organizations to establish a consolidated audit trail system the would enable regulators to track information related to trading orders received and executed across the securities markets.
- adopted rules that would effectively prohibit broker-dealers from providing their customers with unfiltered access to exchanges and alternative trading systems by assuring that broker-dealers implement appropriate risk controls.
The SEC staff is continuing to evaluate further initiatives to address market structure issues revealed by the events of May 6 such as refining the single stock circuit breakers by incorporating a limit-up/limit-down type mechanism.
Click here to access the release approving the rule.