Should Exchanges Impose Market Maker Obligations?
Syracuse University - Whitman School of Management
Southern Methodist University (SMU) - Edwin L. Cox School of Business
Using Toronto Stock Exchange data, we study the trades of Endogenous Liquidity Providers (ELPs), who supply liquidity because it is a profitable activity, and those of Designated Market Makers (DMMs), who have exchange-assigned obligations to maintain markets. We focus on concerns related to fragility and gaps in coverage when markets rely on ELPs for liquidity provision. We show that ELPs are active participants during periods of high volatility and days preceding earnings announcements. However, when market conditions reflect high inventory risk, such as periods with low volume or one-sided order flow, ELPs exercise the option to withdraw from the market. Under these conditions, DMMs earn smaller profits, assume higher inventory risk, and commit more capital, suggesting that liquidity contracts oblige DMMs to participate in undesirable trades, especially in less active stocks, where they are the only reliable counterparties available to investors. Our results document market conditions under which a hybrid market structure, comprising a limit order book and a DMM, improves outcomes for investors, and ultimately the listed firm.
Number of Pages in PDF File: 50
Keywords: designated market maker, high frequency trader, market design, electronic limit order book
JEL Classification: G20working papers series
Date posted: November 21, 2012 ; Last revised: July 17, 2013
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