Market Structure

Regulated Market Maker Exemption

Audited by Cole Barrett • Topic: Market Structure
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Cole Barrett's Reality Check

The Unvarnished Bottom Line

"If an ordinary trader shorts a stock without borrowing the shares first, it is an illegal naked short. But if a designated market maker does it, it is a legal 'liquidity exemption.' While designed to keep markets moving during volatility, quantitative internalizers use this carve-out to trade ahead of real supply and demand."

Interactive Simulator: Test the Math

Interactive Simulator: PFOF Arbitrage Drag

Shares Traded Per Month 2,000 Shares
Estimated Fill Slippage Cost
$40.00 / mo
Sub-optimal fill slippage
Wholesaler Extraction
$480.00 / yr
Sunk annual cost

Real-World Example: Scenario Breakdown

Examining the real numbers for: Retail buying surge of 500,000 shares in a thinly floated momentum equity

Execution Metric Standard Short Seller (Subject to Locate Mandates) Bona Fide Market Maker (Reg SHO Exemption)
Fee / Rate $1.00 fee $0.00 internal
Spread / Buffer Required by Reg SHO to locate verified borrowable shares before shorting Used market maker exemption to short 100,000 shares without a locate
Execution / Status Locate pool empty; broker rejected short sale order Provided immediate selling liquidity to absorb retail buy orders
Total Cost / Result Strict compliance with federal locate rules Legally bypassed the short-sale locate requirement

How Brokers Weaponize This Term

Market makers rely on the bona fide market maker exemption to internalize retail volume on hard-to-borrow stocks, collecting wide spreads while avoiding the locate fees retail traders must pay.

Broker Evaluation Matrix

Cole Approves

Interactive Brokers: Provides institutional transparency into live market-maker short volume ratios and daily short-sale locate availability.

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Cole Flags / Avoids

Wholesale PFOF Desks: Routes client orders to internalizers that rely on market maker exemptions to trade against retail momentum flows.

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Frequently Asked Questions

What defines 'bona fide' market making under Reg SHO?

The market maker must continuously publish two-sided quotes at or near the market and stand ready to buy and sell on a regular basis.

Can market makers keep naked short positions open indefinitely?

No. Under SEC rules, if a failure to deliver (FTD) occurs and persists for a specified number of settlement days, mandatory close-out rules apply.