US regulator the Securities and Exchange Commission (SEC) has approved new rules proposed by US stock exchanges and the Financial Industry Regulatory Authority (FINRA) on 17 September 2010 to strengthen the minimum quoting standards for market makers and effectively prohibit ”stub quotes' in the US 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 during the ”flash crash' on 6 May, when the Dow Jones Industrial Average fell dramatically and recovered in a 20 minute period. Trades for securities that executed at prices more than 60% away from their price at the start of the crash were subsequently broken by FINRA and the exchanges.
The new rules 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 (NBBO).
For securities subject to the US circuit breaker pilot program, currently those in the S&P 500 and Russell 1000 indices, market makers must enter quotes that are not more than 8% away from the NBBO. For the periods near the market open (before 09.45) and market close (after 15.35) when the circuit breakers are not applicable, market makers 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 6 December 2010.
“By prohibiting stub quotes, we are reducing the risk that trades will be executed at irrational prices, and then need to be broken, if the markets become volatile,” said SEC chairman Mary Schapiro. “While we continue to look at other potential obligations for market participants, this is an important step in our effort to improve the functioning of the US markets, and restore investor confidence following the events of May 6.”
Since 6 May, the SEC has approved new rules requiring exchanges to clarify how and when trades would be broken, and effectively prohibit broker-dealers from providing their customers with ”naked access' to exchanges and alternative trading systems by assuring that broker-dealers implement appropriate risk controls.