Abstract
Many exchanges operating an electronic open limit order book employ designated market makers to improve liquidity, particularly for less liquid stocks. Previous research has shown that the existence of a market maker improves liquidity, and that the share price reacts favorably to the announcement that a firm hires a market maker. Little is known, however, about what market makers actually do. We try to fill this gap. Using a data set covering 110 German stocks we analyze the trading activity of market makers in detail. Their participation rates as a function of firm size (or, alternatively, trading volume) display a u-shaped pattern. They are highest for the smallest firms, then decreases in firm size but increases again for the largest size quintile. Market makers not only provide liquidity but also take liquidity. Other traders take liquidity supplied by market makers particularly in times of high volatility, high bid-ask spreads and high informational asymmetries. Finally, we demonstrate that market makers do, on average, not earn profits.
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