In Good Times and in Bad: High-Frequency Market Making Design, Liquidity, and Asset Prices

Abstract

Exploiting two market maker programs and unique data from the Brazilian stock exchange, we answer how a menu of liquidity provision obligations and incentives can improve modern financial markets. We find combining obligations and incentives boosts and stabilizes liquidity, attracting volume and lifting prices. In normal times, these positive effects are driven by incentives, while tight obligations constrain market makers and decrease market quality. In crises, results flip: voluntary activity withdraws which exacerbates liquidity dry-ups; in contrast, tight obligations force market makers to step in as providers of last resort. Overall, our results suggest to combine incentives with countercyclical obligations.

Keywords: Market Making, High-Frequency Trading, Market Design, Liquidity, Crises

JEL Classification: G01, G11, G12, G18, G23