When liquidity in a market dries up, it can contribute to financial disruptions such as the Flash Crash of 2010, when the Dow Jones dropped almost 1,000 points in a matter of minutes.
Traditional thinking has been that natural market forces create enough liquidity to keep markets moving, but an interesting tactic some European companies use caught the attention of Dr. Hendrik Bessembinder, the A. Blaine Huntsman Chaired Presidential Professor in the David Eccles School of Business Finance Department at the University of Utah.
In some European countries, companies will hire what’s called a Designated Market Maker to improve liquidity. Bessembinder detailed his findings in the paper he co-wrote, “Market Making Contracts, Firm Value, and the IPO Decision,” which has been accepted for publication in the Journal of Finance.
“We sat down to do some mathematical modeling of the economics of these markets, and found that indeed there is reason to think that competitive market forces don’t provide as much liquidity as the markets actually need and could benefit from,” Bessembinder said. “ In other words, a contract where somebody is hired to improve liquidity can make sense and improve a company’s value by more than what the designated market makers need to be paid.”
Congress is working to improve liquidity through a pilot program that will increase the tick size of certain small stocks from a penny to a nickel to see if that will increase liquidity. The goal of the pilot program is to encourage IPOs.
“Our model and our study actually leads us to be skeptical that this will be an effective mechanism for enhancing IPOs. In fact, our model says that a designated market contract which is intended to decrease the bid-ask spread can enhance IPOs by improving liquidity and encouraging investors to pay more for shares in an IPO,” Bessembinder said. “Th U.S. Securities and Exchange Commission is going to implement the pilot program where they widen the bid-ask spread. So, it will be of great interest to see if this in fact improves the liquidity of the stocks.”
Bessembinder thinks DMMs could work in U.S. stock markets, but FINRA Rule 5250 expressly prohibits the use of DMMs.
“We actually think that the situation would be improved if the FINRA rule would be repealed to allow firms to have designated market makers in order to improve liquidity,” Bessembinder said.
Click here to listen to a podcast featuring Bessembinder discussing the research he conducted with Jia Hao of the Chinese University of Hong Kong and Kuncheng (K.C.) Zheng of Northeastern University.