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Paying for Market Quality

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Author Info
Amber Anand
Carsten Tanggaard
Daniel G. Weaver () (School of Economics and Management, University of Aarhus, Denmark and CREATES)
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.

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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2007-04.

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Length: 45
Date of creation: 13 Apr 2007
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Handle: RePEc:aah:create:2007-04

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  1. Neal, Robert, 1992. "A Comparison of Transaction Costs between Competitive Market Maker and Specialist Market Structures," Journal of Business, University of Chicago Press, vol. 65(3), pages 317-34, July. [Downloadable!] (restricted)
  2. Madhavan, Ananth & Sofianos, George, 1998. "An empirical analysis of NYSE specialist trading1," Journal of Financial Economics, Elsevier, vol. 48(2), pages 189-210, May. [Downloadable!] (restricted)
  3. Lesmond, David A., 2005. "Liquidity of emerging markets," Journal of Financial Economics, Elsevier, vol. 77(2), pages 411-452, August. [Downloadable!] (restricted)
  4. Scholes, Myron & Williams, Joseph, 1977. "Estimating betas from nonsynchronous data," Journal of Financial Economics, Elsevier, vol. 5(3), pages 309-327, December. [Downloadable!] (restricted)
  5. Huang, Roger D. & Stoll, Hans R., 1996. "Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE," Journal of Financial Economics, Elsevier, vol. 41(3), pages 313-357, July. [Downloadable!] (restricted)
  6. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
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  7. Heckman, James J, 1978. "Dummy Endogenous Variables in a Simultaneous Equation System," Econometrica, Econometric Society, vol. 46(4), pages 931-59, July. [Downloadable!] (restricted)
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  8. Anand, Amber & Weaver, Daniel G., 2006. "The value of the specialist: Empirical evidence from the CBOE," Journal of Financial Markets, Elsevier, vol. 9(2), pages 100-118, May. [Downloadable!] (restricted)
  9. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," Journal of Business, University of Chicago Press, vol. 62(2), pages 211-35, April. [Downloadable!] (restricted)
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