Who monitors the market makers to make sure they don't rip off the traders?

Question

Does the monitoring system work? or do the market makers get rich at our expense?

Answer 1

The SEC regulates marketmakers. Trades on the exchanges are monitored by the exchanges to make sure that the specialists are not breaking the rules. They seem to work pretty well.

OTC stocks (NASDAQ) is another issue. Any investment bank can make a market. The SEC felt that because there would be competition, they didn;t need the same kinds of rules or the same level of monitoring that the NYSE had.

They were wrong. An academic study in the late 1990s showed that investment banks were colluding to keep bid-ask spreads high -- at 0.25 or higher. The paper got a lot of press -- and Congress got involved. The result is Geg-NMS -- which went into effect a few months ago. It put in place better rules and better mechanisms to ensure that trades get the right prices and the right priorities. It won't be perfect -- but will probably work pretty well.

As far as I know, other OTC markets (e.g. bonds) do not have these kinds of rules in place.

Answer 2

I hope by "the traders" you mean the amateur investor, and not the traders on the street; nobody is ripping them off ;-)

Fortunately, nobody (nobody!) is exempt from the securities laws relating to fraud. If you have been deliberately mislead, promised or guaranteed a result, been sold something that was not appropriate for your risk tolerance or portfolio, or even if you just think you MIGHT have been, there is legal action you may take. You're encouraged to contact the state administrator first (think Elliot Spitzer before he became governor - these guys are on YOUR side), but the SEC is an option as well. Civil lawsuits may be brought to recoup losses, in addition to individual brokers being held accountable.