Department of Economics and Business Economics

Paying for Market Quality

Research output: Working paperResearch

  • Carsten Tanggaard
  • Amber Anand, Universit of Central Florida, United States
  • Daniel G. Weaver, Rutgers University, United States
  • School of Economics and Management
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.
Original languageEnglish
Place of publicationAarhus
PublisherCREATES, Institut for Økonomi, Aarhus Universitet
Number of pages45
Publication statusPublished - 2007

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