On Friday, November 5th, the Securities and Exchange Commission (the “SEC”) approved new rules proposed by each of the national securities exchanges and the Financial Industry Regulatory Authority (“FINRA”) to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” in the U.S. equity markets.1 The new rules will become effective on December 6, 2010.
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; for example, an order to buy at one cent or an offer to sell at $100,000. Market makers often enter stub quotes in order to comply technically with the obligation to maintain a two-sided quotation when they do not wish to actively provide liquidity on one or both sides of the market.
However, under certain market conditions, orders may be executed against these stub quotes, which can have a significant impact on the marketplace. For example, according to the SEC, executions against stub quotes represented a significant proportion of the trades that were executed at prices far away from the market during the afternoon of May 6, 2010 (an event now known as the “flash crash”), making them a significant contributing factor in the extremely rapid market decline that took place in a very short period during that day.2 While most of these trades were subsequently broken, their effect on the market that day was extreme. In prohibiting stub quotes, the SEC, FINRA, and the exchanges hope to reduce the risk that trades will be executed at “irrational prices,” and then have to be broken, during periods of extreme market volatility.
The new rules will require 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 (the “NBBO”):
For securities subject to the SEC’s circuit breaker pilot program,3 market makers will be required to enter quotes that are not more than eight percent away from the NBBO;
Before 9:45 a.m. and after 3:35 p.m., Eastern time (i.e., the periods near the open and close, where circuit breakers do not apply), market makers in circuit breaker securities will be required to enter quotes no further than 20 percent away from the NBBO; and
For exchange-listed equity securities that are not included in the SEC’s circuit breaker pilot program, market makers will be required to enter quotes that are no more than 30 percent away from the NBBO.
In each case, the market maker’s quote will be permitted to “drift” an additional 1.5 percent away from the NBBO before the market maker will be required to enter a new quote that is within the prescribed band.
Interestingly, prior to 1997, FINRA’s predecessor, NASD, and the Nasdaq Stock Market, Inc., prohibited market makers in Nasdaq securities from entering quotations that exceeded 125 percent of the average of the three narrowest market maker spreads in the security. This “excess spread rule” was intended to enhance the quality of the Nasdaq market by preventing firms from holding themselves out as market makers without displaying meaningful quotes.
However, in early 1997, based on concerns raised by a number of market participants and the SEC that excess spread limitations were producing unintended consequences that undermined the market’s integrity, potentially discouraging, rather than encouraging, narrower spreads, the NASD and Nasdaq first liberalized the excess spread rule on a pilot basis, and finally, in October of 1997, eliminated it.