The Corner for July 26, 2013

{This is the second of two-part series on the role of the designated market maker at the NYSE}

Designated market makers formerly known as specialists on the floor of the New York Stock Exchange place their market making orders on the NYSE order book along with all public orders. Public order flow can originate from a plethora of sources including retail and institutional investors.

In addition, there is also order flow placed on the order book by NYSE independent floor brokers who represent various institutional investors. The diversity of this order flow provides a constant source of liquidity to the marketplace. However, not all companies nor are their stocks alike.

Ultimately the supply and demand characteristics for the shares of a stock will determine volatility, volumes and pricing. The clear difference between the designated market makers and all other market participants is that only the NYSE designated market maker is charged with dampening volatility and maintaining price continuity for all types of companies under all types of market conditions. This is a pretty tall order in today’s world of speed and technology. But in keeping with the times, the modern aged market maker firms have invested in the most advanced technology and are well prepared to make a market in today’s split second environment.

Still one of the most important roles of a market maker is to “arrange the opening” of a stock. Before trading begins for the day, the market maker reviews the supply and demand picture for orders received since the previous close. It is that person’s responsibility to create an orderly opening auction in light of a multitude of market forces and this all must be done within the defined regulatory framework set upon the designated market maker by the SEC, FINRA and the NYSE. The objective is for the market maker to set a price that reflects a prudent assessment of the broad market and the market factors specific to the stock. The result should be an orderly opening process at a fair price to market participants.

If the volume of buy orders considerably exceeds the volume of sell orders (or vice versa), the price may move swiftly up (or down) at the opening. To prevent this, the designated market maker often supplies stock from their firm’s account. If the security will open significantly up or down ($3 or 10 percent on stocks at $10 or more, $1 on stocks less than $10) from its previous closing price, the market maker must receive approval from an NYSE floor official and is then required to post to the public an indication of the potential price range in which the stock may open. This gives the opportunity for all investors to buy or sell shares during this potentially significant price move up or down. In this way the designated market maker acts as catalyst for generating order flow in the stock. In many instances additional orders will be entered by investors that will offset the imbalance of supply and demand. The stock will then open without a major price change. Imbalances of supply and demand can occur at any point during the trading session for a stock and they often occurs on the closing trade.

This process known as “price discovery” allows for the fairest pricing of the security and helps prevent irrational price movements in the market.

Price discovery is carried out efficiently every day in the market and is seamless to most of the world. Irrelevant of the time or day, it is the designated market maker’s responsibility to provide a fair and orderly market in the securities assigned to him.

So as you can see the specialist or nowadays the designated market maker has many functions on the floor of the NYSE. Providing liquidity (that is buying when no one wants to buy and sell when no one wants to sell) is among the most important and is a key element to keeping our financial markets continuously running.

Quote of the week: “The brave man inattentive to his duty is worth little more to his country than the coward who deserts in the hour of danger.” — Andrew Jackson

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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