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Market Maker Obligations and Sub-Prime CDO Ratings

30

September, 2011

If a sub-prime CDO has a AAA rating then it must be high quality. That’s what investors thought a few years back and we all know how that turned out. How about if a market maker in a stock has “obligations”, then they must be making a tight market during most of the day, right? No, not exactly. Many exchanges and market makers would like you to believe they have obligations but just like the AAA rated sub prime CDO, you have to really investigate what those obligations mean.

At last weeks SIFMA conference, a NYSE executive talked about market maker obligations. Listen to what he said (1 minute mark): Video of SIFMA panel
-”You have a market maker down there with obligations”
-”Market Makers do still have affirmative obligations”
-”Market Makers have the obligation to keep a continuous two sided market”
-”Market makers have a strong obligation at every level”

Sure sounds like today’s market makers have a lot of obligations. But we have a question for them: How far away from the NBBO are you allowed to quote and still be considered a market maker?

Now for a little known answer. Market makers only need to quote within 8% of the NBBO for most securities. There are even some securities where they are allowed to quote within 30% of the NBBO. Read SEC rule here In their December 2010 approval of this rule, the SEC stated:

“By requiring market makers to maintain quotes that are priced within a broad range around the NBBO, the proposed rules should help assure that quotations submitted by market makers to an exchange or FINRA’s ADF, and displayed to market participants, bear some relationship to the prevailing market price, and thus should promote fair and orderly markets and the protection of investors.”

Bear some relationship“, they must be kidding. How does quoting a stock at least 8% away from its NBBO help anybody? Does quoting 8% away from the NBBO help to build a stable, limit order book? This is not an obligation, it’s just a way for the HFT market making firms and their exchange enablers to stand up at conferences and proclaim that they have quoting obligations. But now we know these are really meaningless obligations. Just as meaningless as the AAA rating on the sub prime CDO.

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