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Tighter rules for market makers post-"flash crash"

By Jonathan Spicer

NEW YORK (Reuters) - U.S. exchanges proposed tighter rules for stock "market makers" that are meant to ensure they provide more useful liquidity at extremely stressful times, such as the May "flash crash."

The proposals, submitted to regulators Friday, would effectively eliminate so-called stub quotes that are priced well off the public price of stocks. They would also force market makers to quote no more than 8 percent away from the best bid or offer for stocks covered under new circuit breakers.

The jarring flash crash knocked some 700 points off the Dow Jones industrial average <.DJI> in minutes before it sharply rebounded -- an unprecedented breakdown in the world's most advanced and high-speed marketplace.

It was exacerbated in part because some market markers and other big trading firms stopped trading, sapping the market of buy orders when nearly everyone scrambled to sell. At the depth of the 20-minute crash, scores of trades were executed for as little as a penny, the stub orders.

The proposals were crafted by the major stock markets, including the New York Stock Exchange and the Nasdaq Stock Market, after months of consultation with the U.S. Securities and Exchange Commission. The SEC has yet to fully explain the crash, but says such rules should help prevent a repetition.

The exchanges' proposals are pending SEC approval.

Market makers are firms required to provide both buy and sell orders, or quotes, in specific stocks on the exchanges on which they are registered. The proposals would ensure these quotes stay within specific bands.

The 8 percent band, reported by Reuters in July, relates to stocks covered under the single-stock circuit breakers that were launched in June -- another reaction to the May 6 crash.

More than 1,000 stocks and exchange-traded funds are covered under the circuit breaker rules, which pause trading when these liquid securities move more than 10 percent in five minutes. They include all stocks in the S&P 500 <.SPX> and the Russell 1,000 index <.RUI>.

The circuit breakers are not in effect for the first 15 minutes of the trading day, nor in the last 25 minutes. At those times, market makers would be forced to quote no further than 20 percent away from the best bid or offer in a stock.

For all other stocks, market makers would quote within a 30 percent band, according to the proposals.

"These pricing obligations are intended to eliminate trade executions against (market marker) placeholder quotations traditionally priced far away from the inside market, commonly known as 'stub quotes,'" the NYSE Euronext <NYX.N> letter said.

The proposed bands should help deflect plunging or soaring stocks from tripping the breakers. They could also boost electronic message traffic at exchanges, because market makers will have to adjust their quotes as price bands move.

SEC Chairman Mary Schapiro last week said new rules for market markers should be considered, adding the regulator is in the early stages of considering what benefits these firms should receive in return for new obligations.

Registered market makers are generally required to make two-sided markets. Nasdaq OMX Group Inc's <NDAQ.O> main venue has about 170 market makers.

The Big Board's five "designated market makers" -- including Bank of America Corp <BAC.N> unit BofA Merrill and Barclays Plc <BARC.L> unit Barclays Capital -- are additionally required to post the best bid or offer a specified amount of the time.

(Reporting by Jonathan Spicer; editing by Robert MacMillan and Andre Grenon)

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