Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
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Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
why Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821 The authors are, respectively, Professor of Finance. Doctoral candidate in Finance, and Professor of Finance, in the David Eccles School of Business. University of Utah. The authors thank Shmuel Baruch and Marios Panayides for useful discussions and seminar participants at the University of Utah. U Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821niversity of Auckland. Pontifica Universidade Catolica, Fundacao Getulio Vargas, and Wayne State University for comments.why Designate Market Makers?AHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
ffirmative Obligations and Market Quality/AbstractWe study why many financial markets utilize contracts by which a “designated market maker" precommitwhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821irst relies on the insight that the informational component of the competitive bid-ask spread represents a transfer across traders, not a social cost to completing trades. As such, this cost dissuades efficient trading, which a restriction on spread widths encourages. Secondly, with a restriction on Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821 spread widths more traders choose to become informed, which speeds the rate at which market prices move toward true asset values. We consider a compeHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
titive market setting, where the costs associated with affirmative obligations must be compensated by side payments, as observed on Euronext and the Swhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821r case improves both allocative efficiency and price discovery relative to the fully competitive setting, albeit at a cost to uninformed traders.2I. IntroductionResearchers have, at least since Dcmsctz (1968). emphasized the importance of liquidity in financial markets. liquidity can be supplied thr Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ough quotations in a dealer market or limit orders in an auction market, either of which gives liquidity demanders the option to transact up to a specHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
ified quantity al a specified price. liquidity demanders typically pay liquidity suppliers for the right to transact quickly, in that their buy orderswhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821al markets choose to enter contracts with one or more “designated market makers", who agree to take on certain affirmative obligations to provide liquidity. To be meaningful, these affirmative obligations must require designated market makers to provide liquidity beyond that which they would endogen Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ously choose to provide, in at least some circumstances.The answer to the question of why affirmative obligations are observed is unlikely to simply bHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
e “because liquidity is valuable.” Standard textbook models of a competitive industry imply that, in the absence of barriers to entry to becoming a suwhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821l amount of liquidity, i.e. die amount where the marginal value Io society of increasing liquidity equals the marginal cost to society. Nevertheless. designated market maker's with affirmative obligations arc often observed. Perhaps the most prominent example is the New York Stock Exchange (NYSF.) s Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821pecialist, who is charged with maintaining a “fair and orderly market”.1 However, the NYSE is far1 The specialist has atfiimative obligations ro preveHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
nt discrete price jumps (the “price continuity nite") and to commit capital to improve on rhe best piices in the limit order hook at rimes when endogewhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821s (2006) note that the Tokyo Stock Exchange is the only major stock market that relies entirely on the endogenous submission of limit orders for liquidity provision. Most major stock markets, including the NYSE, the Toronto Stock Exchange, the London Stock Exchange, the Deutsche Bourse, Euronext, an Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821d the main stock markets of Spain, Italy, Greece, Denmark, Austria, Finland, Norway, and Switzerland designate market makers with affirmative obligatiHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
ons to supply liquidity for at least some stocks.We demonstrate two reasons why it can be socially efficient to specify affirmative obligations for dewhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821m spread rule" is by far the most common affirmative obligation noted by Charitou and Panayides (2006) in their survey of international stock markets.We consider two scenarios. In the first, we assume that market making is fully competitive and that the designated market maker has no inherent advant Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821age in terms of information or costs as compared to other liquidity providers. In the absence of restrictions on spread widths, competition leads to qHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
uotations that yield zero-expected profits to market makers on each trade. When instead we obligate the designated market maker to sometimes maintain why Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ld therefore require a subsidy or side payment. Compensation agreements of this type are in fact observed on Euronext, the Stockholm Stock Exchange, and on2https://khothuvien.cori!some other markets, whereby the listed firm makes direct payments to the designated market maker.In the second scenario, Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821 we assume that competition is imperfect, so that an unconstrained market maker has market power to set quotations that yield positive expected profitHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
s. We investigate the effect of a maximum spread rule that constrains spreads at the times when they would be widest, e.g. just after an information ewhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821mproves social efficiency as compared to unconstrained profit maximization by the monopolist market maker. More surprisingly, constraining the monopolist spread such that the market maker earns zero average profit leads to improved social efficiency as compared to the fully competitive zero-profit o Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821utcome. This analysis is suggestive that allowing the designated market maker a degree of market power, along the lines of the NYSE specialist, whoseHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
ability to observe real time conditions on the trading floor provides an informational advantage as compared to off-exchange submitters of limit orderwhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ts of market maker affirmative obligations, we rely on the sequential trade framework of Glosten and Milgrom (1985, henceforth “GM”), which involves informed traders, uninformed (liquidity) traders, and market makers. Within this framework, we consider three benchmarks: outcomes observed when spread Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821s are set by a profit-maximizing monopolist, outcomes observed when spreads are constrained by• Ready (1997) and Harris and Panchapagesan (2005) proviHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
de empirical evidence that (he specialist is able to profit from her information advantage relative to (hose who submit limit orders.3https://khothuviwhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821y optimal trading decisions. GM emphasized the competitive case, and we will refer to quotes observed under the zero-expected profit condition as GM quotes. The first-best benchmark differs from outcomes with the competitive GM quotes due to informational externalities.We then address market perform Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ance, relative to these benchmarks, when an affirmative obligation requires spreads to be narrowed relative to those that would occur endogenously. NaHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
rrowing spreads relative to monopoly levels improves efficiency by encouraging more trading, as would be expected. More surprisingly, narrowing the spwhy Designate Market Makers?Affirmative Obligations and Market QualityHendrik Bessembinder, Jia Hao, and Michael Lemmon*January 20)7Comments Welcome* Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821grom emphasize the competitive bid-ask spread arises in this framework as an informational phenomenon, allowing the market maker to recoup from uninformed traders the losses incurred in transacting with better-informed traders. More generally, the costs incurred by a market maker include costs to so Hutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821ciety as a whole that arise because real resources must be used to complete trades, as well as expected market-maker losses that arise from informatioHutton_Webster_La_magie_dans_les_societes_primitives_ws1034132821
nal asymmetries. However, while the latter reflects a private cost to the market maker, it is a transfer rather than a cost from the viewpoint of sociGọi ngay
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