Do Designated Market Makers Provide Liquidity During Extreme Price Movements?

Abstract

We study the trading activity of designated market makers (DMMs) in a electronic market based on a unique dataset with audit-trail information on trader classification. We test competing theories about the liquidity provision of DMMs in a sample of extreme price movements, where stocks sold off. DMMs may (or may not) stick to their market making agreement and offer immediacy in the wake of heavy selling pressure. They may even decide to lean-with-the-wind in an attempt to profit from private information. We show that DMMs provide liquidity when the selling pressure is concentrated to a single stock, but they consume liquidity when several stocks are affected. In the latter case, the role of liquidity providers is assumed by slow traders.

Keywords: designated market makers (DMMs); extreme price movements (EPMs); high- frequency traders (HFTs); liquidity provision.

JEL Classification: G10, G14