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Friday, July 23, 2010

NYSE Specialists Became DMMs

On the NYSE, "specialists" are now "Designated Market Makers" (DMMs). I spoke with a specialist when DMM was just a proposal. He said "The DMM system is great! The specialists will make easy profits without any risk!"

The DMM gets equal priority with the order book, when filling orders. Suppose an order comes in to sell 1000 shares, and the quote is at least 1000 shares. Then, the specialist buys 500 shares and the order book buys 500 shares. Under the old system, the order book had priority, but the specialist got a "free peek" at incoming orders. Also under the DMM system, the DMM can add liquidity for an order exceeding the quote. However, it's according to a pre-programmed schedule and not a "free peek". That's still a useful perk, because the DMM is trading at a price better than the quote, ahead of other orders on the book.

The DMM gets 50% of all incoming order flow, as long as he joins the quote. How is this a guaranteed riskless profit for the DMM? As usual, I'll illustrate with an example.

Consider a high-volume, low-volatility stock. Most Dow or S&P 500 stocks fall in this category. Suppose the quote is $10.00 bid and $10.01 offer, for a large quantity of shares. The DMM posts a quote, joining the large public offer. The DMM get 50% of all order flow, no matter what.

The DMM gets to buy at $10.00 and sell at $10.01, no matter how many shares are already on the book. The specialist makes a riskless profit of $0.005 per share he buys or sells.

Where does this profit come from? It comes at the expense of the other orders on the book. Suppose the DMM sees that the price may drop; then, the DMM moves his bid from $10.00 to $9.99. The other orders then get filled at an inferior price. When the stock moves up, other orders at $10.00 missed an opportunity to get filled, because the DMM traded ahead of them. The DMM profits come at the expense of other market participants.

The penny quoting rule facilitates this theft. The penny quoting rule says that public quotes must be a multiple of $0.01. In effect, this rule guarantees the specialist a minimum profit of $0.005 per share. If the NYSE quote is $10.00-$10.01, an ECN can't come in with a quote of $10.004-$10.007. (To be fair, the ECN "take liquidity fee", typically $0.003, should be included in the quote.) The penny quoting rule is a way that the NYSE and DMM are protected from competition from ECNs. It imposes a minimum spread of $0.01.

The NYSE switched from "specialists" to "DMMs". The new NYSE rules facilitate DMM theft. The profits of DMMs are pure economic rent. SEC regulation and the penny quoting rule, protects the NYSE from competition. Inflation forces people to invest, lest their savings be stolen via inflation. State regulations and taxes make it hard to invest in physical gold and silver. The slaves are forced into the stock market, a negative sum game.

Even though the DMM himself is not violent, the DMM profits from State violence. The NYSE executives, like all corporate executives, spend a lot of money lobbying Congress and the SEC for favors.

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