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Paying for Market Quality

Published online by Cambridge University Press:  19 October 2009

Amber Anand ,
Carsten Tanggaard  and
Daniel G. Weaver
Amber Anand
Affiliation:
Whitman School of Management, Syracuse University, 721 University Ave., Syracuse, NY 13244. [email protected]
Carsten Tanggaard
Affiliation:
Aarhus University, Bartholins Alle 10, DK-8000 Aarhus C, Denmark. [email protected]
Daniel G. Weaver
Affiliation:
Rutgers University, 94 Rockafeller Rd., Piscataway, NJ 08854. [email protected]
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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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 6 , December 2009 , pp. 1427 - 1457
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

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