Stub quotes new focus of flash crash inquiry

Traders were bewildered as they watched some prices drop to just a penny during the “flash crash” that took place on May 6. In all the “fat” finger pointing that has occurred since, much of the blame has come to rest on stub quotes, a practice the SEC is now considering banning as a result. But for all the blame stub quotes are receiving, few seem to know exactly what they are.

Stub quotes are a tool market makers or exchange specialists are able to use to ensure they are continually meeting their obligation to maintain a two-sided market by both buying and selling. The main idea is that while these market makers are expected to maintain their bids and offers near market levels, because of the speed of the electronic markets there may be times when demand in either direction can outpace the market makers’ ability to fill orders. At times when market makers have either exhausted their liquidity, or are unwilling to provide liquidity, they are able to place a stub quote to act as a place holder at either extreme — that is bids as low as a penny and offers as high as $999,999.999. By doing this they are technically meeting their obligation to maintain a two-sided market.

Theoretically, these extremes were never meant to be executed, but that is what potentially happened on May 6 according to SEC testimony to the U.S. Senate. As prices began falling and stop loss orders were passed, market makers potentially removed their liquidity from the markets placing stub quotes instead. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order, by its terms, will execute against the stub quote. Consequently, we had the absurd reality of valuable stocks selling for just a penny.

Nonetheless, stub quotes are a fairly new arena for the markets. It was only October 2007 when NASDAQ filed with the SEC to eliminate their requirement that market makers’ quotations be “reasonably related to the prevailing market.” BATS did not file to allow the use of stub quotes until January 2009 following the example of NYSE Arca bylaws 7.31 (k) allowing the use of closely related “Q Orders.”

With the results of May 6 in hand, the SEC and CFTC are both considering stub quotes a primary suspect. Even though it is a relatively new practice in the markets, the Dow Jones Newswire reports stub quotes may not be around much longer as new regulation is debated to prevent another “flash crash” from happening.

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