3rd CEPR-Imperial-Plato Market Innovator (MI3) Conference 2019 – Paying for Market Liquidity: Competition and Incentives



3rd CEPR-Imperial-Plato Market Innovator (MI3) Conference 2019

Paying for Market Liquidity: Competition and Incentives


Mario Bellia (European Commission)
Loriana Pelizzon (Goethe University Frankfurt)
Marti Subrahmanyam (Stern School of Business at New York University)
Jun Uno (Waseda Business School)
Darya Yuferova (NHH Norwegian School of Economics)


Mario Bellia is currently Scientific and Technical Officer at European Commission. Prior to that, he spent nine years at the Università Ca’ Foscari di Venezia as a Professor and Research Officer. His research lines include empirical asset pricing, market microstructure (equity and fixed income), high-frequency trading, banking regulation, Fintech and Payment systems.


Loriana Pelizzon is Full Professor of Economics at Ca’ Foscari University of Venice, Italy. She is also the program director of the Systemic Risk Lab and Chair of Law and Finance at Research Centre SAFE at Goethe University in Frankfurt, Germany.


Marti Subrahmanyam is the Charles E. Merrill Professor of Finance, Economics and International Business in the Stern School of Business at New York University, and Global Network Professor of Finance at NYU Shanghai. He holds a degree in mechanical engineering from the Indian Institute of Technology, Madras, and a post-graduate diploma in business administration from the Indian Institute of Management, Ahmedabad.


Jun Uno is a Professor at Waseda University. He held the post of dean from 2006 to 2008 at the Graduate School of Finance, Accounting and Law. Prior to joining Waseda, he served as a Professor at Chuo University from 2002 to 2004. He also held multiple positions including visiting researcher of Ca’ Foscari University of Venice and research fellow of the Center for Financial Studies.


Darya Yuferova is Assistant Professor of Finance at NHH. Darya holds a PhD degree from Rotterdam School of Management, Erasmus University (2016) and a MSc degree in Finance from Duisenberg School of Finance and VU University Amsterdam (2011). During the Fall semester in 2014 she was a Visiting Scholar at NYU Stern Business School. Her research interests include Market Microstructure and Asset Pricing


About the paper


This paper is primarily concerned with looking at ways to encourage increased liquidity on markets in Europe and beyond. Opening by analysing the significant changes that the stock market has undergone over the last ten years, it focuses on the role of ‘Market Makers’ in bringing liquidity to facilitate trading activity.


The analysis is based on NYSE Euronet Paris, with a particular focus on stocks in the CAC40 index, looking at how the introduction of SLP rules for DMMs (designated market makers) have (or have not):

  • Increased requirements,
  • Competition and
  • Rebates


Breaking down the exact changes and tracking the effect that these changes have had on broader trends in market liquidity.


The methodology for the calculations tracked panel regression across stocks for days against sample period, supplementary liquid providers (dummy variable) CAC40 (=1 if the stock belongs to CAC40, and =0 if the stock belongs to DAX30), ‘NonBinding’ (=1 for basket stocks that were not affected by the changing requirements) and controls including market capitalisation, trading volume, stock and market volatility.


For each day, the paper computes the share-weighted average of spreads to assess liquidity variables.


The paper also classifies the sub-categories of Trader: Fast traders, divided into HFT (high frequency traders) and Mixed; Slow traders, categorised as Non HFT. There are also ‘others’ which include propriety trading, customer orders, retail liquidity etc.


The paper concludes with recommendations to the exchanges in light of MiFID II.


Main Takeaways


The paper answers the three points above, arguing the effect on liquidity in DMMs of the following are as follows:

  • Requirements: No
  • Rebates: Yes
  • Competition: Yes, but mainly through a decrease in realised spreads for NON-HFT (high frequency traders)


The paper divides old and new SLP (supplementary liquid provider) rules. Old rules include: committing to be present in one basket of stocks (i.e. 10 out of the CAC 40) and deliver a dime presence of at least 10% of the best bid-offer level for each stock. The rebate for passive execution is 0.20.  The new rules obliged them to be present in all of the CAC40 stocks at a time presence of at least 10%. Minimum time presence is 25% at the best bid-offer level and minimum, passive execution at 0.7%. The rebate was set at 0.22 bps, which was reversed in November 2013.


The data found that HFT-MM and MIX-MM pay the lowest transaction costs, while non-HFT pay the highest transaction costs. It also found that CAC40 and DAX30 had similar liquidity levels in the pre-SLP period, and different ones post SLP.


The research uses heterogeneity across baskets to distinguish between requirements and competition – finding that liquidity increased with the new SLP rules. The finding was that DMMs do adjust their behaviour to fulfil requirements, but not effecting market liquidity: it is competition between DMMs that is the main driver for improvements to liquidity.


The statistics found, through spread decomposition, that liquidity providers lost to HFT-MM and MIX-MM, while making profits on non-HFT; HFT-MM and MIX-MM impose the highest adverse selection costs on the liquidity provider, while non-HFT impose the lowest adverse selection costs.


In terms of spread, the new SLP rules decreased realized spread for NON HFT. There was no consistent pattern for the differences across baskets of stocks for which requirements were binding or non-binding.


In price impact, the SLP rules decreased adverse selection costs for fast traders; with no difference again across baskets of stocks for which requirements were binding or non-binding.


The paper also found that small changes in rebates (around 1% of the quote spread) do not have any effect on market liquidity. However, the new SLP rules did improve liquidity for all transaction sizes. The effect decreased the larger the transaction. In Euronext Paris and Chi-X, transaction costs decreased.