Behavior of Designated Market Makers (DMMs) in Electronic Limit Order Markets and their Role in Enhancing Liquidity of SME Stocks

Part One: Many exchanges operating an electronic open limit order book employ DMMs to improve liquidity, particularly for less liquid stocks. Previous research has shown that the existence of a DMM improves liquidity and that the share price reacts favourably to the announcement that a firm hires a DMM. Little is known, however, about what they actually do. In the first paper, we try to fill this gap. First, we will study the determinants of DMMs’ supply of and demand for liquidity. These determinants include general stock characteristics, the prevailing levels of liquidity and information asymmetry, market makers’ inventory, and the time of day. Second, we will examine whether DMMs succeed in making liquidity more resilient, especially in volatile periods. Third, we will investigate study DMMs’ profitability, which is an important aspect because they are paid by the issuers for the provision of their services while at the same time it has been found that firm value increases when a firm hires a DMM. Part Two: The liquidity of SME stocks listed on public equity markets is an important concern for market operators as well as for the SMEs themselves. Many equity markets employ DMMs in order to ensure a minimum level of liquidity. However, as the use of automated trading technologies has surged, DMMs are often undercut by fast traders (HFTs) who use small orders to marginally improve upon existing prices (“queue jumping”). This potentially leads to reduced trading volume and reduces the incentives for liquidity provision at competitive prices, ultimately leading to less liquidity. Some evidence towards this argument has been recently documented by Korajczyk and Murphy (2014) who find that while HFTs provide more liquidity than DMMs, they scale back their activity during stressful times. The LSE has announced a measure to prevent such queue jumping for small cap stocks ranked outside the FTSE 350 stock index that are traded on LSE’s continuous limit order book. In the second half of 2015, LSE will introduce a minimum order size of a certain percentage of the DMMs’ minimum quote size for orders that improve upon the best bid or ask. This measure is meant to prevent traders from free-riding on DMMs’ prices by employing queue jumping strategies. We will investigate whether this measure encourages increased liquidity provision.