Why Designate Market Makers? Affirmative Obligations and Market Quality

Abstract

While some financial markets increasingly rely on endogenous liquidity provision by “high frequency” traders, others also contract with “designated market makers” who commit to provide more liquidity than they would otherwise choose. We identify two reasons that such affirmative obligations can improve value. The first relies on the insight that the asymmetric information component of market-making costs comprises a transfer across traders, not a social cost to completing trades. As such, this cost dissuades efficient trading, which a restriction on spread widths encourages. Secondly, a restriction on spread widths encourages more traders to become informed, which speeds the rate at which market prices move toward true asset values. This analysis implies that designated market makers can enhance efficiency primarily when actual or perceived information asymmetries are important, not simply when liquidity is expensive or trading is sparse. As the “flash crash” of May 2010 has been attributed to the withdrawal of endogenous liquidity in response to perceived increases in information asymmetries, our analysis implies that future flash crashes can be avoided and social welfare enhanced by designating market makers.

Keywords: designated market maker, affirmative obligation, information asymmetry