Market Maker Inventory, Rule 201, and a Customer In the Middle
Your firm is a registered market maker in ABCD, a Nasdaq-listed stock. Yesterday's close was 16.00. At 11:40 today ABCD trades at 14.35, down about 10.3% from the prior close, and the short sale price test under Rule 201 is in effect for the rest of today and tomorrow. Your quote has been 14.34 bid / 14.36 offered for 500 shares each side. The desk has accumulated a long position of 25,000 shares at an average cost of 15.60 and faces an overnight inventory charge. The head trader wants to sell 30,000 shares before the close to get flat and asks you to route the order now. At the same moment a customer calls and wants to buy 10,000 shares 'at 14.34, the price you were just showing.'
1. How should the 30,000-share sell order be marked, and what constraint applies to each portion?
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Split the order before it leaves the desk.
- Marking: the 25,000 shares the firm owns and will deliver can be marked long. The remaining 5,000 must be marked short. Marking the whole ticket long because the firm 'mostly' owns the stock is a Reg SHO marking violation independent of any pricing issue, and it is the easiest thing for an examiner to find.
- Pricing: Rule 201 applies only to the short portion. With ABCD down more than 10% from the prior close, a short sale may not be executed at or below the national best bid (currently 14.34). The 5,000-share piece needs a print above 14.34. The long portion can be sold at the bid.
- Locate: the 5,000-share short needs a locate or documented pre-borrow. Do not assume the firm's own long position covers it - the position is being liquidated, so the shares will not be available to deliver against a short created simultaneously.
- Whether a market-making exception applies to the short portion is a facts-and-circumstances question the desk cannot self-certify. If the firm is genuinely making a two-sided market and not merely liquidating, compliance should confirm and document the basis before the order is routed.
2. Must the desk fill the customer's 10,000 shares at 14.34?
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Not necessarily, but the answer depends on which inventory the firm is selling from.
- The displayed 14.34 bid is a firm quote for 500 shares. The customer's 10,000 is five times the quoted size, so the firm's display obligation is exhausted at 500 and it has no obligation to fill the full amount at that price. The customer should be told the displayed size.
- The trap: if the firm sells shares it does not own, that is a short sale. At 14.34 - equal to the national best bid - it would be prohibited under Rule 201 absent an exception. Agreeing to the print without knowing the inventory source is how a routine accommodation becomes a violation.
- If the sale comes from the 25,000-share long position, there is no Rule 201 issue and the firm may fill at 14.34 if it chooses. It should then handle the order consistently with its best-execution and order-handling policies, and the fill is reportable like any other.
3. The head trader proposes to simply stop quoting for the rest of the day. What governs that decision?
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Withdrawing is possible but not a free option, and it does not solve the inventory problem.
- As a registered market maker the firm has continuous two-sided quoting obligations while its registration is in effect. It cannot silently stop displaying a quote mid-session; it must follow the exchange's procedures for withdrawal, and if it ceases market making in ABCD it must do so formally and stop representing itself as a market maker.
- If the reason is systems, staffing, or a bona fide regulatory concern, the exchange's excused-withdrawal mechanism is the right tool and the firm must document the basis. 'The stock is going down and we are long' is not an excuse under most exchange rules; it is the risk the firm signed up to carry.
- Withdrawal does not lift Rule 201. Any subsequent short sale in ABCD remains subject to the price test through tomorrow, and the 25,000-share long position still has to be financed or hedged. The desk should price the overnight charge against the cost of selling into a thin, declining market rather than assume withdrawal provides relief.