Market Making Activities
Market makers are the firms that provide liquidity and maintain orderly markets. Understanding their roles, obligations, and the types of quotes they provide is essential for the settlement process.
Designated Market Maker (DMM): NYSE
The DMM (formerly called the "specialist") is assigned to specific securities on the NYSE.
- Maintains a fair and orderly market in assigned securities
- Obligations include:
- Providing continuous two-sided quotes (both bid and ask)
- Facilitating price discovery during openings and closings
- Stepping in as buyer or seller when needed to maintain liquidity
- Must maintain a minimum quote size (size obligation)
- Securities must meet exchange listing requirements (financial thresholds, minimum shareholders) to be assigned to a DMM
Exam Tip: Gotchas
- DMMs provide two-sided quotes (both bid and ask), not just one side. A one-sided quote would not maintain an orderly market.
Market-Wide Circuit Breakers
DMM obligations are suspended during market-wide circuit breakers. Under NYSE Rule 7.12, trading halts when the S&P 500 declines from the prior day's close:
| Level | Decline | Action |
|---|---|---|
| Level 1 | 7% | Trading halted for 15 minutes |
| Level 2 | 13% | Trading halted for 15 minutes |
| Level 3 | 20% | Trading halted for the remainder of the day |
- Level 1 and 2 halts only trigger if they occur before 3:25 PM ET
- Level 3 halts trading for the entire remaining day regardless of time
Exam Tip: Gotchas
- Circuit breaker Level 3 (20% decline) halts trading for the rest of the day, regardless of when it occurs. Levels 1 and 2 only trigger before 3:25 PM ET.
Types of Quotations
| Quote Type | Meaning | Obligation |
|---|---|---|
| Firm quote | The market maker is obligated to buy or sell at the quoted price for at least the quoted size | Must honor |
| Subject quote | Subject to confirmation; the market maker may not honor the quote and must identify it as "subject" | No obligation until confirmed |
| Nominal/informational quote | For informational purposes only; not executable | No obligation |
| Bid wanted (BW) | Requesting bids from other dealers; used when a dealer wants to sell | Soliciting interest |
| Offer wanted (OW) | Requesting offers from other dealers; used when a dealer wants to buy | Soliciting interest |
Exam Tip: Gotchas
- A "firm quote" means the market maker MUST trade at that price. It is the only quote type that creates an obligation. A "subject quote" requires confirmation first. These two are often confused.
Principal vs. Agency Transactions
Every transaction involves the broker-dealer acting in one of two capacities:
| Capacity | Role | Compensation | Example |
|---|---|---|---|
| Principal (dealer) | Trades from own inventory | Markup (on sales) or markdown (on purchases) | Firm sells stock from its inventory to customer |
| Agent (broker) | Executes on behalf of customer | Commission | Firm routes customer order to exchange for execution |
- A firm cannot act as both principal and agent in the same transaction
- The capacity must be disclosed on the customer confirmation
- Markup: the amount added above the prevailing market price when selling to a customer as principal
- Markdown: the amount subtracted below the prevailing market price when buying from a customer as principal
Exam Tip: Gotchas
- A firm cannot be both agent AND principal in the same transaction. If the firm sells from its own inventory (principal), it earns a markup. If it routes to an exchange (agent), it earns a commission. Never both.
SEC Order Handling Rules
- Market makers must display customer limit orders that improve their quote
- Applies to National Market System (NMS) securities
- Designed to ensure customer orders receive best execution
- If a customer's limit order would narrow the spread, the market maker must either execute it or display it
Transaction Reporting
- Market makers must report transactions per exchange and FINRA rules
- Over-the-counter (OTC) market makers in NMS stocks report through the Trade Reporting Facility (TRF)
- FINRA Rule 6000 Series and Rule 6100 Series govern quotation and trading in NMS stocks