What Do Market Makers Achieve?

Abstract

Research on the microstructure of securities markets benefits from a large amount of empirical data. Nonetheless, some relevant questions can only be answered with the help of experiments. Growing competition between different stock exchanges raises the general question of finding the most efficient way to organize securities trade. This paper presents results from a large scale experimental market which was designed to compare different market structures with regard to their ability to efficiently process information and to ensure high liquidity. The past years have witnessed a tendency towards fully computerized markets like the German Xetra trading system which offer a continuous double auction trading platform. However, these markets often experience problems in providing a satisfactory level of liquidity. Some stock exchanges tried to cure the lack of liquidity by introducing market makers. For example, the German stock exchange introduced so called designated sponsors into the Neuer Markt segment within Xetra. Their task is to maintain a liquid market by continuously standing ready to buy and sell securities. Other markets like the option trading segment at EUREX rely on multiple competitive market makers as a source of liquidity. Yet it is empirically not clear to what extent the introduction of market makers achieve its intended purpose. The reason is that empirical studies on this issue are often unable to trace differences in liquidity back to the existence of market makers. Any comparison of different real life securities markets suffers from the notorious problem that markets differ in many more dimension than hust in the existence of market makers. It is therefore difficult to argue that any observed liquidity difference is due to market making. Other institutional aspects such as trading volume, minimum tick sizes, information privileges of some market participants etc. may also contribute to differences in market liquidity.