Journal of Financial and Quantitative Analysis

Research Articles

Paying for Market Quality

Amber Ananda1, Carsten Tanggaarda2 and Daniel G. Weavera3

a1 Whitman School of Management, Syracuse University, 721 University Ave., Syracuse, NY 13244. amanand@syr.edu

a2 Aarhus University, Bartholins Alle 10, DK-8000 Aarhus C, Denmark. ctanggaard@creates.au.dk

a3 Rutgers University, 94 Rockafeller Rd., Piscataway, NJ 08854. daniel_weaver@business.rutgers.edu

Abstract

Many financial markets, including electronic limit order markets, assign designated liquidity providers (LPs). We study the experience of the Stockholm Stock Exchange, where listed firms contract directly with LPs. Our analysis offers insights regarding situations where designated liquidity provision may be beneficial. In addition, we consider the form of liquidity provision contracts, including affirmative obligations required of the LP and compensation for LP services. We find that low current trading activity, wide spreads, and higher information asymmetry increase the attractiveness of contracted liquidity provision. The evidence indicates that LPs trade against market movements and in times of wide spreads. On balance, firms contracting with LPs experience a decreased cost of capital and significant improvements in market quality and price discovery.

Footnotes

We are grateful to Hendrik Bessembinder (the editor) and Jennifer Conrad (associate editor and referee) for insightful and constructive feedback, and to Jim Angel, Ravi Dharwadkar, Vladimir Gatchev, David Goldreich, Terrence Hendershott, Ivalina Kalcheva, Tridib Mazumdar, Albert Menkveld, Marios Panayides, Gideon Saar, Kumar Venkataraman, Yildiray Yildirim, and participants at the WFA 2007 meetings, FMA 2006 meetings, September 2005 Norges Bank Conference on the Microstructure of Equity and Currency Markets, the 2005 Arne Ryde Workshop, and the New York Stock Exchange for helpful comments and suggestions. We thank the Stockholm Stock Exchange for providing the data for this study. We thank Anders Nilsson and Micke Hovmoller for assistance with understanding the rules of the exchange, and Kim Mortensen and Mathias Olausson of OMX for assistance in obtaining the data. Tanggaard gratefully acknowledges research support from CREATES (funded by the Danish National Research Foundation). Weaver gratefully acknowledges partial funding support for this project from the Whitcomb Center for Research in Financial Services.

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