A liquid market ensures investors can trade easily and at low cost. When market liquidity dries up, it can contribute to markets crashing, as during the Flash Crash of 2010, when the Dow Jones dropped nearly 1,000 points in a matter of minutes.

Recently, Dr. Hank Bessembinder provided an in depth analysis of a potential way for the U.S. stock market to stay liquid: use Designated Market Maker (DMM) contracts. They’re already used in some European markets, but not currently allowed in U.S. markets.

It can be efficient and value enhancing for a firm to hire a DMM to help improve liquidity, particularly for companies that are young, unproven and relatively risky, Bessembinder found 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.

Listen to the podcast or read the transcript below to learn more about how DMMs might help improve liquidity for U.S. stock markets.

Eccles School: Welcome to the Eccles Extra Podcast, I’m your host Sheena McFarland. Joining us today is Hank Bessembinder, the A. Blaine Huntsman chaired presidential professor in the Department of Finance at the David Eccles School of Business. His research interests focus on financial markets. He recently co-authored the paper “Market Making Contracts, Firm Value, and the IPO Decision” and it has been accepted for publication in the Journal of Finance. Dr. Bessembinder, thanks for joining us today.

Hank Bessembinder: My pleasure, Sheena.

Eccles School: First, tell me about your research.

Hank Bessembinder: Well our paper focuses on provision of liquidity in the financial markets, the business of keeping the markets liquid so that investors can trade quickly and at low cost. We noticed that it seems like there’s times when liquidity dries up in the markets, in particular the flash crash of 2010, the best-known case where liquidity seems to dry up. We also noticed that some of the European stock markets actually allow — we think it’s a very interesting contract — where a company, a company whose shares are listed on the stock exchange can hire a designated market maker or DMM we call them to improve the liquidity in their stock.

And we found this interesting and as economists at the same time, a little bit puzzling.

To use the phrasing that economists use, there’s no barrier to entry to the business of providing liquidity. If you or I thought that there was good profit to be made providing liquidity, we could open up a brokerage account, start putting in limit orders and be part of the liquidity provision business this afternoon. So we found it to be interesting that there were contracts to improve liquidity beyond what the market was providing. So we sat down to do some mathematical modeling of the economics of these markets and we found that indeed there is reason to think that just competitive market forces don’t provide as much liquidity as the markets actually need and could benefit from.

In other words, a contract to improve liquidity, a contract where somebody is hired to improve liquidity can make sense or can improve the value of the company by more than what the designated market makers need to be paid. So our model helped to identify why that is and in particular, our model helped to identify what kind of companies would benefit from being able to hire a designated market maker. And our models show that it is basically the young, unproven, relatively risky companies, for which the market doesn’t provide enough liquidity and contracts of this type can improve the liquidity. 

Eccles School: Great, so what inspired the research?

Hank Bessembinder: It was the combination of seeing that liquidity seemed to be lacking at times and it seemed to dry up at times and observing that these designated market maker contracts are used in some markets. There is also evidence already out there that when a company announces that it has hired a designated market maker, the stock price reaction is positive. Investors seem to think that this is a good idea and that implies it’s providing value beyond what the company actually has to pay the market makers. It’s making everybody better off. So it was a combination of the apparent lack of liquidity in our own markets at times and the apparent warm reception that these contracts receive when they are used on European markets.

Eccles School: So these designated market makers sound pretty interesting. Tell me a little bit more about them and how they enhance liquidity.

Hank Bessembinder: The most typical contract calls for the designated market maker to keep what we call the bid-ask spread narrow. The limit order traders give the rest of us the option to trade at any given point in time by putting their limit orders on the book. The difference between the lowest selling price and the highest buying price is what’s referred to as the bid-ask spread. One sign of liquidity drying up in the markets is that this bid-ask spread becomes wide. So if the bid-ask spread widens, it’s evidence that liquidity is drying up in the market.

The most common designated market maker contract simply requires that designated market maker to keep the bid-ask spread within a specified amount, say 1 percent or 2 percent. So if the market on its own is not keeping the bid-ask spread narrow, the designated market maker is required to step in and put limit orders into the book and narrow the bid-ask spread. In exchange for that, the company pays designated market maker a periodic monthly fee.

Eccles School: So what effect could your findings have on the way the market functions?

Hank Bessembinder: Well, our thinking that designated market maker contracts can help avoid situations like the flash crash. Situations where people who are providing liquidity literally shut off their computers, that’s when they are worried about what’s going on in the market. So designated market maker contracts could help us avoid situations like the flash crash because someone will be obligated and willing to step up and provide liquidity at difficult times. We also think that designated market maker contracts will enhance IPOs, initial public offerings, that is companies listing their shares for the first time.

It’s been noticed by economists and policy makers that the number of IPOs is down since about a decade ago and there are various theories about why the number of IPOs is down, why the number of firms that are offering shares to the public is down. We think that designated market maker contracts could be at least a partial solution, because a company that hires a designated market maker can essentially sell its shares for a higher price because investors value the additional liquidity in the marketplace. So we think that a designated market maker contract is going to enhance IPOs.

Eccles School: I understand Congress is taking an interest in the lack of IPOs and have put forth some policy initiatives. Can you tell me more about that?

Hank Bessembinder: Yes, it is true. Congress has noted that the number of IPOs is down over the last decade or so and they have proposed that a potential solution is to increase what’s called the tick size in the financial markets. The tick size is the smallest allowable price change in the markets and the relevance of the tick size is that the bid-ask spread can never be narrower than the tick size. So since decimalization of the US markets in 2001, we have had the tick size of a penny, meaning that the bid-ask spread can in principle be as narrow as a penny. The initiatives involve increasing the bid-ask spread for small stocks to a nickel, implying that the bid-ask spread the can never be narrower than a nickel.

As a matter of fact, Congress has instructed the Securities and Exchange Commission to conduct a pilot study where certain small stocks will have their tick size increased to a nickel to see if that can enhance liquidity. And one of the professed goals, one of the stated goals is to also 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 maker 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. The SEC 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.

One other point related to the government policy. The sort of contract that we study in our paper and show to be efficient, the designated market maker contract where the firm hires – the firm whose stock is being traded on the exchange, hires another firm to improve liquidity. That sort of contract is actually not legal in the US currently. There is a FINRA rule — FINRA being the self-regulatory organization — FINRA Rule 5250 that actually prohibits a firm from making payments to a market maker in its stock. So, we actually think that the situation would be improved if the FINRA rule would be repealed and would allow firms to hire a designated market maker to improve liquidity and stock. 

Eccles School: This has been very informative. Thank you so much for joining us today. I’m Sheena McFarland, and this has been the Eccles Extra Podcast.