The Role of Market Makers in the stock market
In order to become a market maker firms have to apply to the stock exchange. They have to demonstrate that they have sufficient capital to provide the liquidity for the number of securities they are applying to make markets in. A stock exchange may assign several competing market makers to a particular security and a market maker may have various “assignments” or securities they are given responsibility for. Getco, which is the largest market maker in US equity markets, makes markets in 500 Canadian securities and more than 300 NYSE securities. Their responsibilities are always monitored by the relevant exchange.
If there is a large selloff, a market maker should buy the shares. However, the flash crash on the NYSE in May 2010 showed that is not always the case. The flash crash knocked nearly 1000 points off the Dow Jones industrial index in just minutes, before sharply rebounding. During the whole incident, which lasted 20 minutes, some market traders stopped trading, reducing the market of buy orders when panic selling started. At the worst of the flash crash, many trades were executed by market makers for as little as a penny. These are called stub orders. In effect, they were adhering to their legal obligations by providing a bid and offer, but they were really trying to avoid participating in the market.
Tighter rules being considered by the Stock Exchange Commission in the US may be enforced to ensure that market makers are around to provide useful liquidity at stressful times. These rules would eliminate stub quotes and would compel market makers to provide prices no more than 8% away from the best bid or offers for stocks that have new circuit breakers. There are 1,000 stocks covered under the new single-stock circuit breakers system which halt trading when prices move more than 10% in five minutes. These are the stocks which make up the Russell 1000 Index and are the top 1000 stocks in terms of market capitalization and index weighting. When the circuit breakers are not in effect – during the first 15 minutes of trading and the last 25 minutes of the day – market makers cannot quote more than 20% away from the best bid or offer. For stocks without circuit breakers, market makers must observe a range of no more than 30% difference than the best bids and offers, according to these proposals.
It is important to remember that market makers in Toronto do not have access to proprietary information nor about the orders entered by others. On the Toronto Stock Exchange, all participants get information at the same time unlike in the US, where market makers get to review the flow of orders. The market maker in Toronto plays a more “passive” role and the job is to provide liquidity and maximize market efficiency.