SEC Toughens Stub Quote Rules

by Glen Shapiro, LawAndTax-News.com, New York

11 November 2010

The United States Securities and Exchange Commission (SEC) has approved new rules 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. 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 May 6 stock market crash (or the “Flash Crash”, as it is called), and subsequently broken.

The new rules, to become effective on December 6, 2010, 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 programme approved earlier this year, market makers must enter quotes that are not more than 8% away from the NBBO; and, for the periods near the daily opening and closing of markets where the circuit breakers are not applicable, market makers in these securities must enter quotes no further than 20% away from the NBBO.

In addition, for exchange-listed equities that are not included in the circuit breaker pilot programme, market makers must enter quotes that are no more than 30% away from the NBBO. In all of the above 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.

"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 L. 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."

It has been pointed out that, since the Flash Crash, the SEC has taken several steps to reduce the chance that the events of that day would happen again. Among other things, the SEC has approved the circuit breaker pilot programme, 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.

It has also approved new rules requiring the exchanges to clarify up-front how and when trades would be broken; and has proposed a new rule that would require the self regulatory organizations to establish a consolidated audit trail system that would enable regulators to track information related to trading orders received and executed across the securities markets.

In addition, rules have been adopted 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.

In conclusion, it was confirmed that the SEC continues 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.

Recommended