Passive Market Making

Passive market making is relief, not a licence. Every condition below is a limit on a market maker that would otherwise have to stand aside for the whole restricted period.

What Does the Relief Cover, and When Is It Unavailable?

Regulation M's passive market making rule permits broker-dealers to engage in market making transactions in covered securities that are Nasdaq securities without violating Regulation M's distribution participant rule.

Its scope sentence then carves out three situations. The rule does not apply:

• To any security for which a stabilizing bid subject to the stabilization rule is in effect.
• During any at-the-market offering.
• During any best efforts offering.

A passive market maker is a market maker that effects bids or purchases in accordance with this rule, and a Nasdaq security is a security authorized for quotation on Nasdaq where that authorization is not suspended, terminated or prohibited.

Exam Tip: Gotchas

• Passive market making cannot run in a security while a stabilizing bid is in effect for it. The trigger is a stabilizing bid subject to the stabilization rule, not stabilizing in general.
• The relief is written for Nasdaq securities. A covered security that is not a Nasdaq security is outside the rule before any condition is tested.

What Are the Two Defined Limits the Conditions Run On?

Two Regulation M definitions supply the arithmetic:

• The 30% ADTV limitation is 30 percent of the market maker's average daily trading volume (ADTV) in a covered security during the reference period, as obtained from the National Association of Securities Dealers, which the rule text names.
• Net purchases is the amount by which a passive market maker's purchases exceed its sales.

Exam Tip: Gotchas

• The 30% figure is measured on the market maker's own volume, not the security's. It is 30 percent of that firm's average daily trading volume in the covered security during the reference period.

What Are the Seven Conditions?

General limitations. A passive market maker must effect all transactions in the capacity of a registered market maker on Nasdaq. It shall not bid for or purchase a covered security at a price that exceeds the highest independent bid for that security at the time of the transaction, except as the duty-to-lower condition permits or as a rule of the Commission or the association governing the handling of customer orders requires.

Purchase limitation. On each day of the restricted period, a passive market maker's net purchases shall not exceed the greater of its 30% ADTV limitation or 200 shares. Together those are its purchase limitation.

• A proviso lets the firm purchase all of the securities that are part of a single order that, when executed, results in its purchase limitation being equalled or exceeded.
• If net purchases equal or exceed the purchase limitation, the firm shall withdraw promptly its quotations from Nasdaq.
• Having withdrawn under that condition, it may not effect any bid or purchase in the covered security for the remainder of that day, irrespective of any later sales during that day, unless the distribution participant rule otherwise permits.

Requirement to lower the bid. If all independent bids for a covered security are reduced to a price below the passive market maker's bid, the firm must lower its bid promptly to a level not higher than the then highest independent bid. A proviso lets it continue to bid and effect purchases at its higher bid until it purchases an aggregate amount of the covered security that equals, or through the purchase of all securities that are part of a single order exceeds, the lesser of two times the minimum quotation size for the security under the association's rules or its remaining purchasing capacity under the purchase limitation.

Limitation on displayed size. At all times, the passive market maker's displayed bid size may not exceed the lesser of the minimum quotation size for the covered security or its remaining purchasing capacity under the purchase limitation. A proviso lets a passive market maker whose purchasing capacity at any time is between one and 99 shares display a bid size of 100 shares.

Identification of a passive market making bid. The bid displayed by a passive market maker shall be designated as such.

Notification and reporting. A passive market maker shall notify the association in advance of its intention to engage in passive market making, and shall submit to the association information regarding passive market making purchases, in such form as the association prescribes.

Prospectus disclosure. The prospectus for any registered offering in which any passive market maker intends to effect transactions in any covered security shall contain the information that the Commission's prospectus disclosure items cited in the rule require.

Exam Tip: Gotchas

• The two provisos pull in opposite directions on small capacity. Once all independent bids fall below its bid, a firm may keep bidding above them until it has bought the lesser of twice the minimum quotation size or its remaining capacity, or exceeds that amount by filling one whole order, yet a firm down to between one and 99 shares of capacity may still display 100.
• Later sales do not reopen the day. Once the firm withdraws for hitting its purchase limitation, it is out of that security for the rest of the day irrespective of any sales it makes afterwards, unless the distribution participant rule otherwise permits.
• The single-order proviso permits an overshoot, not a new limit. It lets the firm complete one order that equals or exceeds the limitation; it does not raise the limitation.

What Price May a Passive Market Maker Never Pay?

No transaction shall be made at a price that the passive market maker knows or has reason to know is the result of activity that is fraudulent, manipulative, or deceptive under the securities laws, or any rule or regulation thereunder.

This condition sits outside the seven and is not measured in shares or percentages. It applies to every transaction the passive market maker effects.

Exam Tip: Gotchas

• The standard is knows or has reason to know. A firm that ignores obvious signs of manipulation cannot rely on the absence of actual knowledge.

What Should You Check on Exam Day?

• Confirm the security is a covered security that is a Nasdaq security, and that no stabilizing bid subject to the stabilization rule is in effect.
• Rule out an at-the-market offering and a best efforts offering before applying the relief.
• Compute net purchases as purchases minus sales, and compare them with the greater of the 30% limitation or 200 shares.
• After a withdrawal for hitting the limit, allow no bid or purchase for the rest of that day regardless of later sales, unless the distribution participant rule otherwise permits.
• Check displayed size against the lesser of minimum quotation size or remaining capacity, then apply the permission to display 100 shares when capacity is between one and 99 shares.