Market Conditions, Obligations and the Economics of Market Making
Syracuse University - Whitman School of Management
Southern Methodist University (SMU) - Edwin L. Cox School of Business
June 14, 2014
Recent regulatory attention has focused on market makers who have no obligations to supply liquidity. Using audit-trail data from Toronto Stock Exchange, we examine how market conditions and exchange-assigned obligations influence the economics of market making. We show that trading profits are higher, inventory risk is lower, and voluntary participation by market makers is higher when both firm and market-wide volatility are high. Market makers scale back on participation when market conditions lower profit potential and increase inventory risk. Under these conditions, market makers with obligations earn smaller profits, assume higher risk, and participate in undesirable trades, especially in less active stocks. Our study identifies circumstances when obligations become binding and highlights the related but largely neglected issue of compensating market makers with obligations.
Number of Pages in PDF File: 51
Keywords: designated market maker, high frequency trader, market design, electronic limit order book
JEL Classification: G20
Date posted: November 21, 2012 ; Last revised: June 26, 2014
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