Who makes markets? The Role of Dealers and Liquidity Provision

Albert Wang and Joon Chae

No 364, Econometric Society 2004 North American Summer Meetings from Econometric Society

Abstract: We explore the role of dealers to determine whether they are liquidity-providing market makers or liquidity-taking information traders. Standard models of market making, such as Kyle (1985) and Grossman and Miller (1988), imply a negative contemporaneous correlation between market maker order flow and stock returns. We test this relation with a unique dataset containing trades of all dealers in a well-developed, liquid market. The correlation is strongly positive, implying that dealers take liquidity. We also develop a unique profit decomposition to compare intraweek information and market making profits. Dealers earn significant excess returns, in aggregate driven by information rather than market making. Subgroup analysis reveals that information profits are positive and increasing in stock capitalization, and market making returns are positive and significant for all but the largest stocks

Keywords: Liquidity Provision; Dealer (search for similar items in EconPapers)
JEL-codes: G10 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-fin
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