Affiliated Market Makers: Caps, Conflicts, and Liquidity Safeguards

Summary

This comment on a proposed CFTC rule considers how exchanges should regulate market makers affiliated with the exchange. It frames the tradeoff between conflict risks, such as self-dealing, and the need for liquidity providers to support new or thinly traded markets. The authors argue that forcing affiliated firms to trade behind unaffiliated firms at every price could expose them to adverse selection while competitors benefit from their liquidity provision.

As an alternative, the letter proposes a 5% cap on affiliated trading once unaffiliated liquidity is sufficient, or a flat 5% exchange-wide cap. It also supports distinguishing bona fide market making from directional trading, while criticizing the proposal’s unclear definitions of directional exposure and hedging. The document argues that uncertainty could deter regulated firms from providing liquidity, but it is an advocacy letter rather than an empirical study and presents no measured market outcomes.

Key ideas

• Affiliated market makers can provide liquidity to emerging markets while also creating potential conflicts of interest.
• The letter argues that mandatory last-in-line priority could expose affiliated firms to adverse selection and weaken liquidity provision.
• It proposes a 5% limit on affiliated trading, conditioned on unaffiliated liquidity or applied across the exchange.
• Clearer definitions of market making, directional positions, and hedging are needed to make compliance workable.
• The claims are policy arguments and are not supported by reported empirical results in the document.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.