The Corner for Feb. 21, 2014

One of the traditional advantages of exchange trading like the orders that are executed on the New York Stock Exchange has been the ease of keeping track of information about securities. Keeping track of the price of a security traded over-the-counter by dealers across the country is a much more formidable task.

At NYSE specialists (designated market makers) act as market markers that stand ready, willing and able to buy or sell in a specified stock they are assigned to. If there are no buyers present, the specialist becomes a willing buyer and if there are no sellers, the specialist becomes a willing seller. In the over-the-counter markets, there are no exchanges and no specialists. However, some over-the-counter broker-dealers make a market in certain securities using inter-dealer quotation services. They keep securities in their inventories, buying and selling them to make markets, for liquidity reasons, for their own profit and at their own risk. Because a broker-dealer acting as a market maker buys and sells for its own account rather than arranging trades between independent parties, it acts as a principal and not an agent when a client buys or sells a stock. The market maker takes a position in the security by purchasing it or selling it short (borrowing to deliver the stock to the individual wanting to buy it). This is called position trading. Securities listed with the NASDAQ must be traded by at least three market makers.

In order for a firm to make a market in a security, it must meet certain minimum Securities & Exchange Commission, Financial Industry Regulatory Authority and NASDAQ standards if the stock is traded on the NASDAQ. Among these the firm (or individual) must:

• be a Financial Industry Regulatory Authority member;

• meet minimum net capital requirements;

• be able and willing to execute a trade for at least a normal trading unit at its quote;

• ensure that its quotations are reasonably related to the current market for that security;

• file daily volume reports for those securities in which it makes a market; and

• perform these functions during normal business hours.

According to Investopedia, “All broker dealers who wish to register as a market maker must file an application with Financial Industry Regulatory Authority and demonstrate that they are in good standing with the authority and that the firm meets the capital requirements to become a market maker. The broker- dealer’s registration will become effective upon notification by the authority. Once approved, a broker dealer must register in each security it wishes to make a market in, prior to quoting that security. Broker dealers may not receive any consideration from the issuer or from promoters for making a market in the security.”

When more than one firm makes a market in a security, the market price of that security results from competition among the broker-dealers. A registered representative (stockbroker) who takes a client’s order to buy an over-the-counter stock turns the order over to a trader at the firm, who may contact several market makers and arrange the trade at the lowest offering price. If only one firm makes a market in a particular security, it cannot claim to be offering that security “at the market.” As the only dealer in that stock, the firm (not a market of competing buyers and sellers) plays the major role in setting the price.

Quote of the Week: “We do not remember days, we remember moments.”—Cesare Pavese

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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