Should Exchanges Impose Market Maker Obligations?
Social Science Research Network
We study the trades of two important classes of market makers, Designated Market Makers (DMMs) and Endogenous Liquidity Providers (ELPs). The former have exchange-assigned obligations to supply liquidity while the latter do so voluntarily because it is a profitable activity. Using Toronto Stock Exchange data, we show how trading profits, inventory risk, and capital commitments influence the market maker's decision to supply liquidity in the cross-section of stocks and under different market
... ifferent market conditions. ELPs maintain a market presence and supply liquidity in large stocks. For other stocks, a DMM is the only reliable counterparty available for investors. When profit opportunities are small or inventory risk is substantial, ELPs exercise the option to withdraw from the market. Under these conditions, DMMs earn smaller trading profits, assume more inventory risk, and commit more capital suggesting that liquidity contracts oblige the DMMs to participate in undesirable trades, especially in less active stocks. Overall our evidence points to the suitability of a hybrid market structure, comprising a limit order book and a DMM, to trade less active securities. We should consider the relevance today of a basic premise of the old specialist obligations -that the professional trading firms with the best access to the markets (and therefore the greatest capacity to affect trading for good or for ill) should be subject to obligations to trade in ways that support the stability and fairness of the markets. 2 Recent studies conclude that the activities of the algorithmic traders improve market liquidity (Hendershott, Jones and Menkveld (2011), Hasbrouck and Saar (2011) ) and enhance the price discovery process (Hendershott and Riordan (2010)). Menkveld (2011) and Baron, Brogaard and Kirilenko (2012) estimate that the Sharpe ratio of HFTs exceeds 9.0, suggesting that their trades are highly profitable. 3 The vast majority of stocks listed in equity exchanges today are thinly traded. The problem is more acute in the fixed income market where secondary market trading for the majority of corporate bonds and structured credit products is extremely sparse (see Bessembinder, Maxwell and Venkataraman (2013) ).