What does it mean to be a market maker?

The auction rate securities debacle (which was discussed recently here) raises the question of what should be the legal responsibilities of any entity that claims to be a market maker.

It is generally acknowledged (but not necessarily accepted) that market makers exit the market in extreme events.  This can be viewed as understandable given that the market makers themselves are unlikely to understand the cause of extreme fluctuation and therefore will face significant uncertainty as to what constitutes a profitable pricing schema in these circumstances.  On the other hand once the market has settled into a new pricing “equilibrium”, the market makers are expected to come back and perform their role in setting prices.  That is, market making involves continuously posting prices with a few short-lived exceptions.

It’s not clear that a “market maker” can reserve the right to stop making a market and still call itself a market maker.  That is, a crucial element of the definition of a market maker is that it is a firm that enters into an obligation to continuously post prices.  Every participant in the market is an occasional trader.  If the definition of a market maker is allowed to include entities that can decide not to trade in the given market, then there really is no difference between a market maker and an occasional trader — that is, the term market maker has been stripped of its meaning.

Proposal:  Regulators should create formal definitions for the marketing materials for over the counter markets.

For example, when claiming to be a market maker for an over the counter product, a firm engages itself to be a market maker for the life of the product.


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