Designated Market Maker

Rule 104(c) imposes an affirmative obligation on DMMs to maintain, insofar as reasonably practicable, a fair and orderly market on NYSE in assigned securities. That obligation includes maintaining price continuity with reasonable depth and trading for the DMM's own account when lack of price continuity, lack of depth, or disparity between supply and demand exists or is reasonably to be anticipated. Rule 104(e) describes the Trading Floor functions of DMMs.

DMMs are required to maintain price continuity with reasonable depth, which they achieve by quoting not only at top of book, but also providing liquidity at multiple price levels to help dampen volatility. A DMM has unique responsibilities to actively make markets, which means to quote bids and offers throughout the trading day, both at the inside market prices and throughout the order book. As the market maker dedicated to a security, a DMM can provide real-time market insight to issuers. Registered market makers, in contrast, have flexibility to participate when conditions are favorable and remain largely anonymous.

From Specialists to DMMs

In October 2008 the Securities and Exchange Commission approved the elimination of specialists and the creation of Designated Market Makers, with implementation in phases and certain key provisions approved on a pilot basis. Under NYSE's proposal, DMMs would be employees of Designated Market Maker Units, known as DMM Units.

One DMM for Each NYSE Listed Security

There is one DMM assigned to each NYSE listed security, and the NYSE market model features a Designated Market Maker for each listed security.

Under NYSE Rule 103B(III), an issuer may select a DMM unit after interviewing all DMM units eligible to participate in the allocation process, or delegate the authority for selecting its DMM unit to NYSE. A DMM unit's eligibility to participate in the allocation process is based on objective criteria and determined at the time the interview is scheduled.

NYSE American has electronic Designated Market Makers, known as eDMMs, with quoting obligations for each NYSE American listed company. An eDMM has obligations to maintain fair and orderly markets for its assigned securities, and there is one eDMM assigned to each NYSE American listed security.

Becoming a DMM

A member organization that wants to operate a DMM unit must file a written application and be approved before operating a DMM unit. DMMs are required to be a member of NYSE and pass a prescribed examination.

Opening and Closing Auctions

The DMM is responsible for executing the NYSE Opening and Closing Auctions, and is obligated to ensure all marketable auction orders receive an execution. The DMM is obligated to conduct the auction and, if needed, can participate in the auction to help produce a price that more accurately reflects market conditions.

Rule 104 makes the DMM responsible for facilitating openings and reopenings for each security in which the DMM is registered, which may include supplying liquidity as needed. A pre-opening indication is the price range within which the opening price for a security is anticipated to occur, and NYSE Rule 15 sets out the requirements for it.

Under NYSE Rule 104(a)(3), DMMs have the responsibility to facilitate the close of trading for each of the securities in which the DMM is registered, which may include supplying liquidity as needed. NYSE Rule 7.35B(g) makes the DMM responsible for determining the Auction Price for a Closing Auction.

One of the DMM's obligations is to facilitate the closing auction process, which includes setting the closing price at a level that satisfies all interest that is willing to participate at a price better than the closing auction price. DMMs typically participate by offsetting any remaining auction imbalances that exist at the closing bell. In special situations, a DMM can delay the close and seek additional imbalance-offsetting liquidity.

Market Makers and Dealers

A market maker is a firm that stands ready to buy or sell a stock at publicly quoted prices. Under Section 3(a)(38) of the Securities Exchange Act of 1934, a market maker is any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out, by entering quotations in an inter-dealer communications system or otherwise, as being willing to buy and sell such security for his own account on a regular or continuous basis.

The definition uses the term dealer. Under Section 3(a)(5)(A) of the same Act, a dealer is any person engaged in the business of buying and selling securities for such person's own account through a broker or otherwise, with a parenthetical that addresses security-based swaps. Under Section 3(a)(4)(A), a broker is any person engaged in the business of effecting transactions in securities for the account of others.

Regulation of the National Market System, known as Regulation NMS, in which NMS stands for national market system, contains Rule 600, which defines both an exchange market maker and an over-the-counter market maker. An exchange market maker is any member of a national securities exchange that is registered as a specialist or market maker pursuant to the rules of that exchange. An over-the-counter market maker, written OTC market maker in the rule, is any dealer that holds itself out as being willing to buy from and sell to its customers, or others, in the United States, an NMS stock for its own account on a regular or continuous basis otherwise than on a national securities exchange in amounts of less than block size.

Reading a Quote: Bid, Ask and Spread

The bid is the highest price a buyer will pay to buy a specified number of shares of a stock at any given time. The ask is the lowest price at which a seller will sell the stock. The bid price will almost always be lower than the ask, or offer, price. The difference between the bid price and the ask price is called the spread.

For over-the-counter market securities, the bid is the highest price a market maker will pay at any given time to purchase a specified number of shares of a stock, and the ask is the lowest price at which a market maker will sell the stock. Market makers make their money on the spread.

Under Rule 600, a bid or offer is the bid price or the offer price communicated by a member of a national securities exchange or member of a national securities association to any broker or dealer, or to any customer, at which it is willing to buy or sell one or more round lots of an NMS security, as either principal or agent. Indications of interest are not included. The best bid and best offer are the highest priced bid and the lowest priced offer.

Quotation size, for a responsible broker's or dealer's bid or offer for an NMS security, is the number of shares, or units of trading, of that security which the responsible broker or dealer has specified, for purposes of dissemination to vendors, that it is willing to buy at the bid price or sell at the offer price comprising its bid or offer, as either principal or agent. If the responsible broker or dealer has not so specified, quotation size is a normal unit of trading for that NMS security.

The round lot for an NMS stock is set by reference to the average closing price of the stock on its primary listing exchange during the prior evaluation period, and Rule 600 separately addresses a security that becomes an NMS stock during an operative period. An odd-lot is an order for the purchase or sale of an NMS stock in an amount less than a round lot.

Firm Quotes: Rule 602

Rule 602 of Regulation NMS governs the dissemination of quotations in NMS securities. Under Rule 602(a)(1), each national securities exchange must, at all times it is open for trading, collect, process, and make available to vendors the best bid, the best offer, and aggregate quotation sizes for each subject security listed or admitted to unlisted trading privileges that is communicated on any national securities exchange by any responsible broker or dealer, subject to the exclusions the rule lists. Each national securities association must, at all times that last sale information with respect to NMS securities is reported pursuant to an effective transaction reporting plan, collect, process, and make available to vendors the best bid, best offer, and quotation sizes communicated otherwise than on an exchange by each member acting as an OTC market maker for each subject security, together with the identity of that member and excluding any bid or offer executed immediately after communication, except during any period when over-the-counter trading in that security has been suspended.

Under Rule 602(b)(1), each responsible broker or dealer must promptly communicate to its national securities exchange or national securities association, pursuant to the procedures established by that exchange or association, its best bids, best offers, and quotation sizes for any subject security.

A responsible broker or dealer, for bids and offers communicated by a member of an association to a broker or dealer or a customer, is the member communicating the bid or offer, regardless of whether the bid or offer is for its own account or on behalf of another person. For bids and offers communicated on a national securities exchange, a responsible broker or dealer is a member who communicates a bid or offer to another member at the location, or through the facility, designated by the exchange for trading, as either principal or agent.

A published bid and published offer is the bid or offer of a responsible broker or dealer for an NMS security communicated by it to its national securities exchange or association pursuant to Rule 602 and displayed by a vendor on a terminal or other display device at the time an order is presented for execution to that responsible broker or dealer.

Under Rule 602(b)(2), subject to paragraph (b)(3), each responsible broker or dealer is obligated to execute any order to buy or sell a subject security, other than an odd-lot order, presented to it by another broker or dealer, or by any other person belonging to a category of persons with whom the responsible broker or dealer customarily deals, at a price at least as favorable to the buyer or seller as the responsible broker's or dealer's published bid or published offer, in any amount up to its published quotation size. The comparison is exclusive of any commission, commission equivalent or differential customarily charged by the responsible broker or dealer in connection with execution of the order.

Rule 602(b)(3) limits that obligation. Under Rule 602(b)(3)(i), a responsible broker or dealer is not obligated to execute a transaction in an amount greater than a revised quotation size if, before the order is presented, it has communicated a revised quotation size to its exchange or association, or if, when the order is presented, it is in the process of effecting a transaction in the security and, immediately after the completion of the transaction, communicates a revised quotation size.

Under Rule 602(b)(3)(ii), a responsible broker or dealer is not obligated to execute a transaction as provided in paragraph (b)(2) if, before the order is presented, it has communicated a revised bid or offer, or if, when the order is presented, it is in the process of effecting a transaction in the security and, immediately after the completion of the transaction, communicates a revised bid or offer. In the second case it is nonetheless obligated to execute the order at its revised bid or offer in any amount up to its published quotation size or revised quotation size.

Backing Away and Firm Quotations

Rule 5220 of the Financial Industry Regulatory Authority, known as FINRA, prohibits a member from making an offer to buy from or sell to any person any security at a stated price unless the member is prepared to purchase or sell, as the case may be, at that price and under the conditions stated at the time of the offer to buy or sell.

Members and persons associated with members in the over-the-counter market make trading decisions and set prices for customers upon the basis of telephone and electronic quotations, including quotations displayed in an inter-dealer quotation system. In some instances a dealer's quotations, purportedly firm, are, in fact, so qualified upon further inquiry as to constitute "backing away" by the quoting dealer. Backing away from quotations disrupts the normal operation of the over-the-counter market.

Members change inter-dealer quotations constantly in the course of trading. Under normal circumstances where a member is making a "firm trading market" in any security, it is expected at least to buy or sell a normal unit of trading in the quoted stock at its then prevailing quotations, unless the quotation is clearly designated as not firm or firm for less than a normal unit of trading when supplied by the member.

If, at the time an order for the purchase or sale of the quoted security is presented, the member is in the process of effecting a transaction in that security, and immediately after the completion of the transaction communicates a revised quotation size, the member is not obligated to purchase or sell the quoted security in an amount greater than the revised quotation size.

Every member has an obligation to correctly identify the nature of its quotations when they are supplied to others, and each member furnishing quotations must ensure that it is adequately staffed to respond to inquiries during the normal business hours of the member. A failure to fulfill these obligations is deemed inconsistent with Rule 2010 and Rule 5220.

A normal unit of trading for an NMS stock is the round lot assigned to the stock pursuant to Rule 600(b) of Regulation NMS, and the term inter-dealer quotation system is as defined in Rule 6420.

Quotations Must Be Bona Fide

FINRA Rule 5210 prohibits a member from publishing or circulating, or causing to be published or circulated, any notice, circular, advertisement, newspaper article, investment service, or communication of any kind which purports to report any transaction as a purchase or sale of any security unless the member believes that the transaction was a bona fide purchase or sale of the security. The same prohibition applies to a communication that purports to quote the bid price or asked price for any security, unless the member believes that the quotation represents a bona fide bid for, or offer of, the security.

Trading Ahead of Customer Orders

FINRA Rule 5320 is the Prohibition Against Trading Ahead of Customer Orders. Except as the rule provides, a member that accepts and holds an order in an equity security from its own customer or a customer of another broker-dealer without immediately executing the order is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account. The Supplementary Material to Rule 5320, paragraphs .01 through .05, sets out exceptions.

Market Makers on Nasdaq

A member registered as a Nasdaq Market Maker must engage in a course of dealings for its own account to assist in the maintenance, insofar as reasonably practicable, of fair and orderly markets in accordance with Nasdaq Equity 2, Section 5, Market Maker Obligations.

For each security in which it is registered, a Nasdaq Market Maker must be willing to buy and sell the security for its own account on a continuous basis during regular market hours and must enter and maintain a two-sided trading interest, called the Two-Sided Obligation. The rule sets further requirements for that interest, including that it be displayed in the quotation montage at all times.

The core duty is similar on NYSE and Nasdaq: a course of dealings for the market maker's own account to assist in the maintenance of fair and orderly markets, insofar as reasonably practicable.

How Orders Reach Markets and Market Makers

For a stock that is listed on an exchange, a broker may direct an order to that exchange, to another exchange, or to a firm called a market maker. A broker generally has a choice of markets to execute a customer's trade.

A broker may send an order for a stock that trades in an over-the-counter market to an over-the-counter market maker. A broker may route an order, especially a limit order, to an electronic communications network that automatically matches buy and sell orders at specified prices. A broker may also send an order to another division of the broker's firm to be filled out of the firm's own inventory.

The opportunity for price improvement is an important factor a broker should consider in executing its customers' orders. Price improvement is the opportunity, but not the guarantee, for an order to be executed at a better price than the current quote. A broker is required to consider whether there is a trade-off between providing its customers' orders with the possibility, but not the guarantee, of better prices and the extra time it may take to do so.

Exam Relevance

The Securities Industry Essentials examination content outline lists "Traders and market makers" in Topic 1.1.4, Market Participants and their Roles, in Section 1, Knowledge of Capital Markets. Topic 3.1.1, Orders and Strategies, in Section 3, Understanding Trading, Customer Accounts and Prohibited Activities, lists "Buy and sell, bid-ask" and "Trade capacity", with principal and agency named in the parentheses of the trade capacity bullet. Topic 3.3.1, Market Manipulation, lists backing away among its types of market manipulation.

The list of rules that follows Topic 3.3.3 includes FINRA Rule 5210, Publication of Transactions and Quotations, Rule 5220, Offers at Stated Prices, Rule 5310, Best Execution and Interpositioning, and Rule 5320, Prohibition Against Trading Ahead of Customer Orders. Candidates should check the current outline before the examination.

Common Misunderstandings

More than one DMM is assigned to each NYSE listed security. There is one DMM assigned to each NYSE listed security.

A DMM only brings buyers and sellers together. A DMM is required to engage in a course of dealings for its own account to assist in the maintenance of a fair and orderly market insofar as reasonably practicable.

A DMM has no part in the opening and closing auctions. The DMM is responsible for executing the NYSE Opening and Closing Auctions.

The issuer has no say in who its DMM is. An issuer may select a DMM unit after interviewing the eligible DMM units, or delegate the authority for selecting its DMM unit to NYSE.

DMMs appear only on the New York Stock Exchange. NYSE American has electronic Designated Market Makers, and there is one eDMM assigned to each NYSE American listed security.

The bid price is the higher of the two quoted prices. The bid price will almost always be lower than the ask, or offer, price.

A displayed quotation is only an advertisement that the quoting firm may ignore. Each responsible broker or dealer is obligated to execute an order covered by Rule 602(b)(2) at a price at least as favorable as its published bid or published offer in any amount up to its published quotation size, subject to Rule 602(b)(3).

A firm quotation can never change. Members change inter-dealer quotations constantly in the course of trading, and Rule 602(b)(3) addresses what happens when a responsible broker or dealer communicates a revised bid, offer or quotation size.

A quotation is firm whatever its label. A member is expected to buy or sell a normal unit of trading at its then prevailing quotation unless the quotation is clearly designated as not firm or firm for less than a normal unit of trading when supplied by the member.

Nasdaq market makers have no continuing quotation duty. A member registered as a Nasdaq Market Maker must, for each security in which it is registered, be willing to buy and sell the security for its own account on a continuous basis during regular market hours.

A member that holds a customer order may freely trade the same security for its own account on the same side of the market. Rule 5320 prohibits trading at a price that would satisfy the customer order unless the member immediately thereafter executes the customer order up to the size and at the same or better price, and the rule has exceptions.

Key Points to Retain

A DMM has obligations to maintain fair and orderly markets for its assigned securities, and one DMM is assigned to each NYSE listed security.

Rule 104(a) requires DMMs to engage in a course of dealings for their own account to assist in the maintenance of a fair and orderly market insofar as reasonably practicable.

Rule 104(c) includes maintaining price continuity with reasonable depth and trading for the DMM's own account when lack of price continuity, lack of depth, or disparity between supply and demand exists or is reasonably to be anticipated.

The DMM is responsible for executing the NYSE Opening and Closing Auctions and is obligated to ensure all marketable auction orders receive an execution.

An issuer may select its DMM unit after interviewing eligible DMM units, or delegate the selection to NYSE.

The bid is the highest price a buyer will pay, the ask is the lowest price at which a seller will sell, and the difference between them is the spread.

Under Rule 602(b)(2), a responsible broker or dealer is obligated to execute an order covered by the rule at a price at least as favorable as its published bid or published offer in any amount up to its published quotation size, subject to Rule 602(b)(3).

Rule 5220 prohibits an offer at a stated price unless the member is prepared to purchase or sell at that price and under the conditions stated at the time of the offer.

Quotations that are purportedly firm but are, in fact, so qualified upon further inquiry as to constitute "backing away" disrupt the normal operation of the over-the-counter market.

Rule 5320 prohibits a member that holds a customer order from trading the same security on the same side of the market for its own account at a price that would satisfy the customer order, unless the member immediately thereafter executes the customer order, and the rule has exceptions.