What Is an Affirmative Obligation?
In finance, the term “affirmative obligation” refers to the responsibilities of market makers working on the New York Stock Exchange (NYSE). These market makers are also known as “specialists” of the NYSE.
- An affirmative obligation is the responsibility of NYSE specialists to provide market-making services for a particular security.
- Today, the NYSE’s market makers are known as designated market makers (DMMs).
- Their affirmative obligation responsibilities include providing stock quotations, limiting market volatility, and informing the opening and closing prices of certain securities. To incentivize these activities, the NYSE offers various rebates to their designated market makers (DMMs).
How Affirmative Obligations Work
In the course of trading, it is common for the demand for specific securities to occasionally outstrip the supply, or for the opposite to occur. In either case, the market makers of the NYSE would be required under their affirmative obligations mandate to buy or sell shares in order to maintain an orderly trading environment.
Specifically, in the case of demand far outstripping supply, market makers could be required to sell inventory in that security. Likewise, if supply outstrips demand, they may be required to purchase shares. In this manner, the affirmative obligations mandate helps ensure that supply and demand are kept in a reasonably close balance, thereby decreasing price instability.
As the NYSE has become increasingly automated in recent years, the role of specialist market makers has similarly evolved. Today, the traditional role of the NYSE specialist has been replaced by DMMs. In addition to balancing supply and demand, these important actors also bear additional responsibilities, such as establishing appropriate opening prices for securities and working to reduce the transaction costs faced by investors.
Real World Example of an Affirmative Obligation
Additional practices which fall under the affirmative obligation framework of modern DMMs include: maintaining orderly trading in the opening and closing periods of the trading day; providing quotes on the best available stock prices; and overseeing processes which remove market liquidity from the market, in order to manage risk.
In some cases, the NYSE will assist these DMMs by providing rebates for market-making activities. These rebates are designed to incentivize prudent and effective market-making activities, and are therefore tethered to outcomes such as the accuracy of quoted prices, the level of market liquidity, and the quality of quotes available for thinly-traded securities.