Paying for Market Quality

Amber Anand, Carsten Tanggaard and Daniel G. Weaver ()
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Daniel G. Weaver: School of Economics and Management, University of Aarhus, Denmark and CREATES, Postal: 8000 Aarhus C, Denmark

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: Since the affirmative obligations of liquidity providers are costly, electronic markets have struggled with the means of providing compensation to liquidity providers in return for assuming these obligations. This problem is acute for small stocks, which benefit most from the presence of designated liquidity providers. In this study, we examine the 2002 decision by the Stockholm Stock Exchange to allow listed firms to directly negotiate with liquidity suppliers for a desired level of liquidity in exchange for a negotiated fee. We find that benefits accrue to firms that enter into such arrangements in the form of significant improvements in market quality as well as price discovery. Further, we find that a firm’s stock price rises in direct proportion to the improvements in market quality. We study the determinants of the compensation for liquidity provision and document a link between contracted fees and the level of desired liquidity. By examining the trading of liquidity providers we find that their propensity to supply liquidity increases at times of large spreads, and against market movements. Our findings suggest that firms should consider these market quality improvement opportunities as they do other capital budgeting decisions, especially in light of the positive externalities that we find accrue to the liquidity of the firms’ stocks.

Pages: 45
Date: 2007-04-13
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