Making The Market

In a revealing section of this week’s joint CFTC/SEC report on “the market events of May 6 2010” (now popularly known as the “flash crash”), the regulators describe how market makers’ obligations to quote two-way prices on US national securities exchanges were subtly altered three years ago.

The report’s authors explain that a key responsibility for members of US securities exchanges is “to maintain a continuous two-sided quotation in the security or securities for which the member is registered as a market maker.”

However, the report continues, “such rules…do not generally dictate the prices at which a market maker must quote.” Observing the letter of the law, but not its spirit, market makers are therefore considered to be quoting two way prices even if the bid side of the quote is a “stub” price of a cent. It was precisely these “stub quotes” at ridiculously low prices that got hit by electronic trading programmes on May 6, resulting in catastrophic, 99%-plus price declines in affected stocks and ETFs.

Interestingly, as the CFTC/SEC report elaborates, until a few years ago market makers had an additional obligation to maintain quotes that were “reasonably related to the prevailing market.” But lobbying from the exchanges led to the scrapping of this rule.

Here, for example, is Nasdaq’s 2007 justification for removing the “reasonably related to the prevailing market” requirement. “Nasdaq believes that the requirement is no longer a meaningful means of ensuring market execution quality in the highly competitive and increasingly automated environment in which Nasdaq and other trading venues now operate.”

In hindsight, this was a misjudgement. Increasing competition and the automation of trading does not automatically ensure “market execution quality”, as investors found out on May 6.

But would the maintenance of a requirement on market makers to keep quotes close to prevailing prices have helped? In Europe, several exchanges place exactly such obligations on market makers, making them keep bid-offer spreads within predetermined percentage limits. The London Stock Exchange, for example, segregates ETFs into three bands according to the funds’ underlying liquidity, and prescribes that market makers keep the gap between their bid and offer prices within a 1.5%, 3% or 5% limit, depending on the band the fund falls into.

There are get-out clauses, however: the obligations are lifted if no firm prices are available on more than 10% of the ETF’s underlying index constituents, and market makers can also apply to have the obligations suspended if no price is available for any underlying constituent. So there’s no guarantee that market makers can be relied upon to provide quotes within these price bands in unstable markets.

It’s also worth remembering that the “reasonably related to the prevailing market” requirement for US exchanges’ market makers was not failsafe, either. Ironically, this rule was originally introduced in 1987, a few months before the most spectacular crash in history. Despite market makers’ notional obligations at the time, many investors complained that during the 1987 crash traders did not pick up their phones to quote prices, or stopped providing bid prices on the floor of the NYSE.

In an interesting comparison of the events of October 19 1987 and May 6 2010, one trader reminds us that “in the 1987 crash, every major firm pulled out. In every break you find evidence of major firms withdrawing their buying and selling interest from the market.”

So there’s no foolproof mechanism to ensure that the market functions smoothly at all times. During panics, price dislocations are inevitable and liquidity disappears. Regulators’ rules don’t guarantee investors’ safety. If there is any silver lining to the “flash crash”, it might have been to remind us, as investors, of these basic facts.

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