Securities regulators are moving quickly to tighten rules for market makers to ensure there is liquidity during stressful times and avoid a repetition of May's brief market crash, said sources familiar with the discussions.

The U.S. Securities and Exchange Commission and big exchanges are considering eliminating so-called stub quotes, or orders placed by market makers that tend to be well off the market price, four sources said.

The SEC and the exchanges are also eyeing minimum obligations for market-making firms that would force them to submit quotes that are less than 10 percent away from a stock's current price, the sources said.

One of the sources said a rule proposal could come within weeks. Another source said the SEC is trying to firm up the market-making rules before it must start crafting dozens of new rules prescribed by financial reform legislation.

The sources requested anonymity because the talks are continuing.

The flash crash, which is still unexplained, saw the Dow Jones Industrial average fall some 700 points within just minutes, then sharply rebound. The bounce rattled investors globally and sparked a handful of rule proposals.

The SEC has been hindered by its inability to see the entire marketplace and has proposed improving market surveillance by tracking stock orders across all U.S. equity markets in real time.

One key response was new market-wide circuit breakers, adopted last month, that halt trading when a stock moves 10 percent within five minutes. The new market-making obligations would force registered firms to quote inside that 10 percent band, the sources said.

An 8 percent quote band is an option being considered, two sources said.

Market makers typically use their own capital to take both sides of the market, essentially buying and selling without taking long-term bets so that investors can easily trade. The disappearance of useful liquidity is seen as a cause of the flash crash.

The crash also brought calls for a crackdown on stub quotes, which are standing orders well off the current price of a stock. Many stubs placed by market makers and others were executed on May 6, for as little as a penny.

(S)tub quotes are not intended to be executed and effectively indicate that the market maker has pulled out of the market, the SEC and the Commodity Futures Trading Commission said in a joint May 18 report.

We will examine the extent to which market makers used stub quotes to nominally meet market-making obligations on May 6.

'FRONT AND CENTER'

Market-making rules are front and center for the SEC now, one source said. Another said the agency's focus on the issue has intensified this week.

An SEC spokesman declined to comment.

SEC Chairman Mary Schapiro, speaking in Chicago on Friday about the flash crash investigation, said in prepared remarks that the agency was looking at potentially significant imbalances between buyers and sellers that may have been exacerbated by the withdrawal of liquidity usually provided by a variety of market participants.

Registered market makers on Nasdaq OMX Group Inc's Nasdaq Stock Market, NYSE Euronext's Arca exchange and BATS Exchange are generally required to make two-sided markets. The Nasdaq has about 170 market makers.

The Big Board's five designated market makers -- including Bank of America Corp unit BofA Merrill and Barclays Plc unit Barclays Capital -- are additionally required to post the best bid or offer a specified amount of the time. Any new market-wide rules could deal with this and with incentives for market makers.

Forcing market makers to quote inside the 10 percent circuit breaker threshold would likely help deflect plunging or soaring stocks from tripping the breakers. It could also significantly boost quote traffic at exchanges, where trading and data dissemination is high-speed and mostly electronic.

In Washington, Democrats are trying to shepherd the financial reform bill through Congress so President Barack Obama can sign it into law. The bill requires the SEC to adopt rules to supervise hedge fund advisers and the over-the-counter derivatives market, among other things.

(Reporting by Jonathan Spicer in New York and Rachelle Younglai in Washington; edited by Gerald E. McCormick, John Wallace and Andre Grenon)

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