Designated Market Makers Research Articles

The Information Content of Quotes in High Frequency Order Driven Markets

This paper investigates the information content present in the quotes in an order driven market without the presence of designated market makers. A representation is proposed that recognises the ability of participants in such markets to observe market events and calibrate their quoting activity. The public signal of the asset price formed after a general consensus among participants is seen to be a part of the price system. Information aggregates into the public signal with a low frequency to negate microstructure and trading effects.

High-Frequency Market Making to Large Institutional Trades

We utilize a unique data set that provides all orders and trades, with (masked) trader identity known, for all equities traded on Canadian exchanges. We identify and characterize designated market makers (DMMs) and high frequency traders that act as market makers (HFTs). We also identify large institutional trade packages and characterize how HFTs and DMMs provide liquidity to these trades. Both HFTs and DMMs provide liquidity to large institutional trades, with HFTs providing substantially more. In high volume stocks, HFTs reduce liquidity provision for “stressful” trades by 42 percent while DMM liquidity provision remains mostly unchanged. Implementation shortfall (price) of large trades is significantly affected by HFT (and to a lesser extent DMM) choice of liquidity provision during the trade. ∗We thank the Investment Industry Regulatory Organization of Canada (IIROC) for providing us with access to the data used for this study and Victoria Pinnington and Helen Hogarth of IIROC for answering our innumerable questions regarding the data and Canadian market structure details. We also thank Torben Andersen, Oleg Bondarenko, Kevin Crotty, Hanh Le, and Brian Weller for useful comments on the paper. All errors are our own. †Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL, 60208-2001; tel: (847) 491-8336; e-mail: r-korajczyk@kellogg.northwestern.edu. ‡University of Illinois at Chicago, College of Business, Department of Finance, 601 South Morgan Street, Chicago, IL, 60607-7121; tel: (312) 355-4372; e-mail: murphyd@uic.edu.

Designated market makers still matter: Evidence from two natural experiments

Independent technological glitches forced two separate trading halts on different U.S. exchanges during the week of July 6, 2015. During each halt, all other exchanges remained open. We exploit exogenous variation provided by this unprecedented coincidence, in conjunction with a proprietary data set, to identify the causal impact of Designated Market Maker (DMM) participation on liquidity. When the voluntary liquidity providers on one exchange were removed, liquidity remained unchanged; when DMMs were removed, liquidity decreased market-wide. We find evidence consistent with the idea that these DMMs, despite facing only mild formal obligations, significantly improve liquidity in the modern electronic marketplace.

Market Makers under Extreme Market Conditions: Does Timing Matter?

This research tests the impact of the nomination of designated market makers in various market conditions. We explore the effect of such announcements on three dimensions: liquidity, volatility, and returns. The findings suggest that, despite the positive contribution that these announcements make to a stock’s liquidity and regardless of the market conditions or the preliquidity levels, they may increase the volatility that accompanies market trends in extreme market conditions. The results have important policy implications because they support the attitude of regulators who tend to postpone the introduction of new mechanisms for enhancing market efficiency during abnormal market conditions and wait for more conventional conditions. Furthermore, contrary to the general view, the results suggest that introducing market makers may not be a stabilizing mechanism. Therefore, regulators should examine alternative stabilizing mechanisms that account for extreme market conditions.

Designating market maker behaviour in limit order book markets

Financial exchanges provide incentives for limit order book (LOB) liquidity provision to certain market participants, termed designated market makers or designated sponsors. While quoting requirements typically enforce the activity of these participants for a certain portion of the day, an argument that liquidity demand throughout the trading day is far from uniformly distributed is made, and thus this liquidity provision may not be calibrated to the demand. Furthermore, it is propose that quoting obligations also include requirements about the speed of liquidity replenishment, and then a recommendation that use of the Threshold Exceedance Duration (TED) for this purpose be considered. To support this argument a comprehensive regression modelling approach using GLM and GAMLSS models to relate the TED to the state of the LOB and identify the regression structures that are best suited to modelling the TED is presented. Such an approach can be used by exchanges to set target levels of liquidity replenishment for designated market makers.

Designated Market Makers Still Matter: Evidence from Two Natural Experiments

Designated Market Makers Still Matter: Evidence from Two Natural Experiments

Designated Market Makers Still Matter: Evidence from Two Natural Experiments

Designated Market Makers Still Matter: Evidence from Two Natural Experiments

Liquidity provision and stock return predictability

This paper examines the trading behavior of two groups of liquidity providers (specialists and competing market makers) using a six-year panel of NYSE data. Trades of each group are negatively correlated with contemporaneous price changes. To test for return predictability, we sort stocks into quintiles based on each group’s past trades and then form long-short portfolios. Stocks most heavily bought have significantly higher returns than stocks most heavily sold over the two weeks following a sort. Cross-sectional analysis shows smaller, more volatile, less actively traded, and less liquid stocks more often appear in the extreme quintiles. Time series analysis shows the long-short portfolio returns are positively correlated with a market-wide measure of liquidity. A double sort using past trades of specialists and competing market makers produces a long-short portfolio that earns 88 basis points per week (act as complements). Finally, we identify a “chain” of liquidity provision. Designated market makers (NYSE specialists) initially trade against order flows and prices changes. Specialists later mean revert their inventories by trading with competing market makers who appear to spread trades over a number of days. Alternatively, specialists may trade with competing market makers who arrive to market with delay.

How do designated market makers create value for small-caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days (days when their constraint is likely to bind). Finally, DMMs reduce the size of pricing errors.

Designated Market Makers in Electronic Limit Order Books - A Closer Look

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.

Why Designate Market Makers? Affirmative Obligations and Market Quality

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.

How Do Designated Market Makers Create Value for Small-Caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.

Information Contents of Trade and Quote Imbalances, and the Hypothesis of Reverse Liquidity: Evidence from a Fully Automated Exchange

In this paper, we study the information contents of imbalances in trades and quotes emanated from an exchange resembling the one envisioned by Black (1971). We find dollar volume is more informative than number in measuring daily trading and quoting activities. Our measure of quote imbalance permits an investigation on the information asymmetry between market and limit orders. In case insider trading does not occur regularly, we present a hypothesis of reverse liquidity as an alternative interpretation of our empirical findings. It could be that market-order traders charge an implicit liquidity premium for fulfilling the contrarian trading demand of limit-order traders. We suspect proprietary traders are filling the vacuum created by the absence of designated market makers and they provide reverse liquidity through their active trading.

How Do Designated Market Makers Create Value for Small-Caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.

Are Designated Market Makers Necessary in Centralized Limit Order Markets?

This paper models price formation and order placement strategies in a dynamic centralized limit order market with designated non monopolist market makers. This market design differs from the NYSE and has been adopted by several stock exchanges in Europe and North America mainly for the trading of mid caps. The model is constructed as an extension of Foucault (1999) in order to include market makers who are required to provide two-sided quotes in the book. Traders can place either a market order or a limit order and, in the latter case, they can choose the order's limit price. Comparison between a limit order market with market makers and a pure limit order market yields several testable implications. First, the clearing frequency is higher in a limit order market with designated market makers. Second, the best quotes in the limit order book with market makers are either more or less attractive than in a pure order book depending on whether the best quote has been placed by a trader or a market maker. On an ex ante basis, we find that expected best quotes in the order book can be more or less favourable in the presence of market makers depending on the asset volatility and the differences in valuation among traders. The model thus yields empirical predictions relative to the added value of non monopolist market makers across assets and/or periods. Other things equal, expected best prices in a limit order book with market makers become more attractive than in a pure limit order book when the asset volatility increases. Since asset volatility decreases with equity capitalisation, our results provide a rationale for the trading of mid caps being organized as limit order books with designated dealers. By contrast, the presence of market makers on large capitalisation stock markets could deteriorate market liquidity.

Institutional Design and Liquidity at Stock Exchanges around the World

The paper investigates the trading mechanism and other structural features of 51 stock exchanges and analyzes the impact of these institutional characteristics on liquidity measures such as closing bid-ask spreads, volatility and trading turnover. Exchange-design features such as narrower tick sizes, designated market makers, consolidated limit order books, hybrid trading mechanisms, automated trade execution, consolidated order-flow, and better shareholder rights are associated with lower spreads. These features also influence volatility and trading turnover, which in turn further affect spreads. Overall liquidity is highest on hybrid trading mechanisms compared to pure limit order books or quote-based dealer system because the former have two sources of liquidity. These results have important implications for investors' trading strategy, firms' listing strategy, and exchanges' organizational strategy.

Do designated market makers improve liquidity in open‐outcry futures markets?

AbstractOn February 1, 2002, the Chicago Board of Trade appointed a designated market maker to enhance liquidity in its 10‐year interest rate swap futures contract. This market‐making program is the first of its kind in the open‐outcry futures industry. We find that introduction of the market maker has increased volume and reduced transaction costs. The market maker has also enhanced the speed and the efficiency of price discovery. Overall, the results suggest that the market‐making program is successful in improving liquidity. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:479–502, 2004

Information-Based Trading in the Treasury Note Interdealer Broker Market

Despite its pervasive presence in world financial markets, there are few studies of interdealer broker markets. This paper examines the trading behavior of primary dealers in the 5-year Treasury note interdealer broker market. The analysis examines trading patterns, announcement effects, and volatility–volume relations. The results show that trading frequency is consistent with activity motivated by public information or dealer's private knowledge of inventory or order flow information. Additionally, although the interdealer broker market is an anonymous electronic compilation and matching system without designated market makers, trade size does not appear to have any information content. Journal of Economic Literature Classification Numbers: C22, G14.

Liquidity Providers on an Electronic Order-Driven Market

The Taiwan Stock Exchange (TSEC) is an electronic order-driven market without designated market makers. By turnover rate the TSEC is the most liquid market in the world. This paper is about the liquidity providers on the TSEC. Our analysis sheds light on the design of trading mechanism of an order driven market that fosters liquidity providing behavior of its participants. We identify institutional traders such as depository institutions, corporations, insurance companies, and investment companies as viable liquidity providers. They trade heavily, make handsome profits, and their trading profits increase with trading volume as well as the frequency of participation in trades. They have some timing and securities selection ability. They use limit orders extensively and mix limit and market orders in their trading strategy. However, they provide less than 4% of the liquidity on the TSEC. The bulk of the liquidity on the TSEC is provided by individual investors who use limit orders extensively. Our analysis indicates that the TSEC can be characterized as a market where every participant has a good chance of making short-term capital gains. Very few viable liquidity providers make persistent profits. The transaction cost on the TSEC is low. There is no equity requirement for submitting orders. The market is fair in the sense that every trader has the same trade information and trade access.

The Role of Tick Size in Upstairs Trading and Downstairs Trading

This paper examines the impact of reducing the tick size on market-making behavior on The Toronto Stock Exchange. The results indicate a significant decrease in the percentage of trades of fewer than 10,000 shares involving the upstairs traders and a significant increase in the percentage of trades of fewer than 1,000 share involving the designated market makers. Consistent with this finding, the upstairs traders earn significantly lower returns on non-block trades and the designated market markers earn lower returns on trades smaller than 1,000 shares. We conclude the tick size reduction benefits the trading public.Journal of Economic LiteratureClassification Numbers, G20, G24.