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.

[1]  Y. Amihud,et al.  Illiquidity and Stock Returns II: Cross-Section and Time-Series Effects , 2018, The Review of Financial Studies.

[2]  L. Pedersen,et al.  Asset Pricing with Liquidity Risk , 2003 .

[3]  Kalok Chan,et al.  Information Asymmetry and Asset Prices: Evidence from the China Foreign Share Discount , 2008 .

[4]  Robert M. Mooradian.  Illiquidity and Stock Returns , 2010 .

[5]  Ľuboš Pástor,et al.  Liquidity Risk and Expected Stock Returns , 2003, Journal of Political Economy.

[6]  L. Glosten.  Is the Electronic Open Limit Order Book Inevitable , 1994 .

[7]  Christine A. Parlour,et al.  Liquidity-Based Competition for Order Flow , 2003 .

[8]  H. Mendelson,et al.  Market Microstructure and Securities Values: Evidence from the Tel Aviv Stock Exchange , 1996 .

[9]  Charles M. Jones,et al.  Time Variation in Liquidity: The Role of Market Maker Inventories and Revenues , 2008 .

[10]  Chester Spatt,et al.  An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse , 1995 .

[11]  George Sofianos,et al.  Specialist Gross Trading Revenues at the New York Stock Exchange , 1998 .

[12]  B. Rindi,et al.  Market Makers as Information Providers: The Natural Experiment of STAR , 2010 .

[13]  Kerry Back,et al.  Working Orders in Limit-Order Markets and Floor Exchanges , 2005 .

[14]  David Eccles.  Why designate market makers ? Affirmative obligations and market quality , .

[15]  Marios A. Panayides.  Affirmative Obligations and Market Making with Inventory , 2005 .

[16]  M. Nimalendran,et al.  Do `thinly-traded¿ stocks benefit from specialist intervention? , 2003 .

[17]  Y. Amihud,et al.  Asset pricing and the bid-ask spread , 1986 .

[18]  David B. Audretsch,et al.  Innovation in Large and Small Firms: An Empirical Analysis , 1988 .

[19]  Avanidhar Subrahmanyam,et al.  The Going‐Public Decision and the Development of Financial Markets , 1999 .

[20]  Thomas J. George,et al.  Information Flow and Pricing Errors: A Unified Approach to Estimation and Testing , 2001 .

[21]  Jerry W. Liu.  An Analysis of Individual NYSE Specialist Portfolios and Execution Quality , 2009 .

[22]  Marco Pagano,et al.  Trading Volume and Asset Liquidity , 1989 .

[23]  Zoltan J. Acs,et al.  Are small firms important? : their role and impact , 1999 .

[24]  R. Levine,et al.  Stock Markets, Banks, and Economic Growth , 1996 .

[25]  K. Venkataraman,et al.  The Value of the Designated Market Maker , 2005, Journal of Financial and Quantitative Analysis.

[26]  Bruno Biais,et al.  Price Discovery and Learning during the Preopening Period in the Paris Bourse , 1999, Journal of Political Economy.

[27]  J. Heckman.  Sample selection bias as a specification error , 1979 .

[28]  Pierre-Olivier Weill,et al.  Leaning Against the Wind , 2003 .

[29]  Hyuk Choe,et al.  Does the Specialist Matter? Differential Execution Costs and Intersecurity Subsidization on the New York Stock Exchange , 1997 .

[30]  A. Anand,et al.  Paying for Market Quality , 2009 .

[31]  Maureen O'Hara,et al.  Information and the Cost of Capital , 2001 .

[32]  Jean Tirole,et al.  Market Liquidity and Performance Monitoring , 1993, Journal of Political Economy.

[33]  S. B. Thompson.  Simple Formulas for Standard Errors that Cluster by Both Firm and Time , 2009 .

[34]  Thomas Braun,et al.  C-It: a knowledge database for tissue-enriched genes , 2010, Bioinform..

[35]  Chris J. Muscarella,et al.  Market microstructure and securities values: : Evidence from the Paris Bourse , 2001 .

[36]  Luigi Zingales,et al.  Financial Dependence and Growth , 1996 .

[37]  Siem Jan Koopman,et al.  Modeling Around-the-Clock Price Discovery for Cross-Listed Stocks Using State Space Methods , 2004 .

[38]  M. Arellano,et al.  Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations , 1991 .