Bona Fide Market Making Activity Should Include Trading Interest Other Than Quotations

As part of a recent rulemaking, the Securities and Exchange Commission ("Commission" or "SEC") adopted Rule 3a5-4 to include certain liquidity providers within the meaning of the phrase "as a part of a regular business" in the rule and thereby requiring those liquidity providers to register with the Commission and relevant self-regulatory organizations ("SRO") as dealers. The entities meeting the requirements of the phrase in that rule would be those that engage "in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants . . . ."

The SEC proposed two ways in which an entity could be providing such liquidity:

(1) regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants; or

(2) earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest.

It is important to note that the Commission intentionally chose the term "trading interest" rather than the term "quotations" because it "would reflect the prevalence of non-firm trading interest offered by marketplaces today, and account for the varied ways in which developing technologies permit market participants to hold themselves out as willing to buy or sell securities, or otherwise communicate their willingness to trade, and to effectively make markets." The Commission even went so far as to acknowledge its prior outdated focus on "quotations" by stating that "use of the term 'trading interests' was intended to update the Commission's long-standing understanding that regular or continuous 'quotation' is a hallmark of market making or de facto market making . . . to reflect the various and evolving ways in which buyers and sellers of securities are brought together."

In referencing its outdated focus on "quotations," the Commission footnoted its prior statement regarding bona fide market making and that such activity involves "continuously placing quotations in a quotation medium on both the bid and ask side of the market." Its updated viewpoints on how entities can provide liquidity should inform what activity may be considered in determining whether an entity is engaged in bona fide market making. In particular, the Commission appears to be recognizing that market making and liquidity providing activities are constantly evolving, and what may have been an appropriate description in 1993 is now too narrow.

Such an approach comports with the legislative history of the 1975 amendments to the Exchange Act, which were designed to foster competition among market makers, regardless of the form that such market making activity took. In 1975, Congress amended the Exchange Act of 1934, including by adopting Section 11A, to create a National Market System for securities.[1] In adopting Section 11A, Congress found that:

[i]t is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure—

(i)        economically efficient execution of securities transactions;

(ii)       fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets (emphasis added);

(iii)      the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities;

(iv)      the practicability of brokers executing investors' orders in the best market; and

(v)       an opportunity, consistent with the provisions of clauses (i) and (iv) of this subparagraph, for investors' orders to be executed without the participation of a dealer.

The legislative history of these amendments clearly demonstrates Congress's intent to promote, among other things, a market structure that assists brokers in seeking best execution for their clients' orders and competition, through the creation of competing market centers (including various types of market makers), that fosters investor protection and fair and orderly markets.

For example, the Senate Committee Report for the amendments noted that the fundamental goals of a national market system include: (1) providing an investor or his broker with the ability to be able to determine, at any given time, where a particular transaction can be effected at the most favorable price; and (2) creating an incentive for multiple market makers to deal in depth on a continuous basis.[2] In other words, in the national market system, investors should be able to obtain the best execution of their orders and be assured that because of open competition among market makers, the total market for each security is as liquid and orderly as the characteristics of that security warrant.

To achieve the objectives of a national market system, the Senate Committee Report stated that the first order of priority in creating a national market system was to break down unnecessary regulatory restrictions that impede contact between brokers and market makers and that restrain competition among markets and market makers.[3] The Senate Committee Report noted that a healthy, highly competitive system of market makers is essential to an efficient national market system and noted that investigations by the Senate Committee demonstrated that in the increasingly complex and institutional markets, a single specialist, regardless of the regulation and exhortation to which he is subject, cannot provide adequate liquidity and continuity to the market for a security.[4]

An outdated definition of bona fide market making, which unnecessarily focuses on quotations rather than trading interest, would hinder the natural development of the national market system and contravene the underlying purposes of the 1975 amendments. The Commission, in its recent rulemaking, appears to have finally recognized the diversified nature of market makers in the way they make markets. Accordingly, market makers should be able to use trading interest, other than quotations, to meet the requirements of the bona fide market making exception to the "locate" requirement in Regulation SHO.