Market Making Contracts, Firm Value, and the IPO Decision

• Author: JIA HAO,HENDRIK BESSEMBINDER,KUNCHENG ZHENG
• Date: 01 October 2015
• DOI: http://doi.org/10.1111/jofi.12285
• Published date: 01 October 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 5 •OCTOBER 2015

Market Making Contracts, Firm Value,

and the IPO Decision

HENDRIK BESSEMBINDER, JIA HAO, and KUNCHENG ZHENG∗

ABSTRACT

We examine the effects of secondary market liquidity on firm value and the IPO deci-

sion. Competitive aftermarket liquidity provision is associated with reduced welfare

and a discounted secondary market price that can dissuade IPOs. The competitive

market fails in particular for firms or at times when uncertainty regarding fundamen-

tal value and asymmetric information are large in combination. In these cases, firm

value and welfare are improved by a contract where the firm engages a designated

market maker to enhance liquidity. Such contracts represent a market solution to a

market imperfection, particularly for small, growth firms.

MODERN STOCK MARKETS RELY ON COMPETING limit orders to supply liquidity.

In contrast to the designated “specialists” who in past decades coordinated

trading on the flagship New York Stock Exchange (NYSE), limit order traders

are typically not obligated to supply liquidity or otherwise facilitate trading.

The desirability of such endogenous liquidity provision has recently been ques-

tioned. As Mary L. Shapiro, former chair of the U.S. Securities and Exchange

Commission (SEC) noted, “The issue is whether the firms that effectively act

as market makers during normal times should have any obligation to support

the market in reasonable ways in tough times.”1A joint Commodity Futures

∗Bessembinder is at Arizona State University and the University of Utah, Hao is at the Chi-

nese University of Hong Kong, and Zheng is at Northeastern University. Earlier versions of this

manuscript were titled “Market Making Obligations and Firm Value.” The authors thank Robert

Battalio, Thierry Foucault, David Hirshleifer, Michael Lemmon, Marios Panayides, Hans Stoll,

Avanidhar Subrahmanyam, an anonymous Associate Editor, two anonymous referees, as well as

seminar participants at Northwestern University, University of Washington, University of Pitts-

burgh, Brigham Young University, University of Illinois, Case Western Reserve University, Cass

Business School, Southern Methodist University,University of Texas at Austin, the New Economic

School, University of Auckland, University of Sydney, University of California at Irvine, Pontifica

Universidade Catolica, Fundacao Getulio Vargas, Arizona State University, Cheung Kong Gradu-

ate School, Tsinghua University, the Asian Bureau of Finance and Economic Research Conference,

the 2013 Financial Management Association Conference, YorkUniversity, University of Michigan,

Babson College, Peking University,Xiamen University, Chinese University of Hong Kong, the U.S.

Securities and Exchange Commission, and the University of Massachusetts for useful comments.

Special thanks are due to Bruno Biais and Uday Rajan for their modeling suggestions and insights.

1Speech to the Economic Club of New York, September 7, 2010. Available at http://www.

sec.gov/news/speech/2010/spch090710mls.htm.

DOI: 10.1111/jofi.12285

1997

1998 The Journal of Finance R

Trading Commission–SEC advisory committee observed that “incentives to dis-

play liquidity may be deficient in normal markets, and are seriously deficient

in turbulent markets.”2The SEC Advisory Committee on Small and Emerging

Companies recently recommended an increase in the minimum price incre-

ment or “tick size” for smaller exchange-listed companies to “increase their

liquidity and facilitate IPOs and capital formation.”3Such policy initiatives

are predicated on the notion that competitive market forces do not always

supply sufficient liquidity.

In this paper, we introduce a simple model of secondary market illiquidity

and its effect on stock prices and incentives to conduct IPOs. Our model shows

that competitive secondary market liquidity provision can indeed be inefficient,

and can lead to market failure. Failure occurs particularly for those firms or

at those times when the combination of uncertainty regarding asset value and

the likelihood of information asymmetry is high.

As a potential cure, we focus on contracts where the firm hires a designated

market maker (DMM) to enhance liquidity.Such contracts are observed on sev-

eral stock markets, including the leading markets in Germany, France, Italy,

the Netherlands, Sweden, and Norway.4The most frequently observed obliga-

tion is a “maximum spread” rule, which requires the DMM to keep the bid-ask

spread (the difference between the lowest price for an unexecuted sell order

and the highest price for an unexecuted buy order) within a specified width, in

exchange for a periodic payment from the firm.5DMM contracts of this type

are currently prohibited in the United States by Financial Industry Regulatory

Authority (FINRA) Rule 5250, which “prohibits any payments by an issuer or

an issuer’s affiliates and promoters . . . for publishing a quotation, acting as

a market maker or submitting an application in connection therewith.”6The

NYSE and Nasdaq markets have both recently requested partial exemptions

from Rule 5250, to allow DMM contracts for certain exchange traded funds.7

Some commentators have criticized these proposals on the grounds that DMM

contracts distort market forces.8

2Recommendations Regarding Regulatory Responses to the Market Events of May 6, 2010, Sum-

mary Report of the joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. Available

at http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/jacreport_021811.pdf.

3Recommendations Regarding Trading Spreads for Smaller Exchange-Listed Compa-

nies, U.S. SEC Advisory Committee on Small and Emerging Companies. Available at

http://www.sec.gov/info/smallbus/acsec/acsec-recommendation-032113-spread-tick-size.pdf.

4See, for example, Venkataramanand Waisburd (2007), Anand, Tanggaard, and Weaver (2009),

Menkveld and Wang(2013), Skjeltorp and Odegaard (2015), and Petrella and Nimalendran (2003).

5Such obligations typically bind. For example, Anand, Tanggaard, and Weaver (2009)study

DMM agreements on the Stockholm Stock Exchange and document that the contracted maximum

spreads are typically narrower than the average spread that prevailed prior to the introduction of

DMMs. In contrast, the “supplemental liquidity suppliers” currently employed on the NYSE are

only obligated to enter orders that match the best existing prices a certain percentage of the time,

and are not required to improve on the best prices from public limit orders.

6FINRA rules are available at http://finra.complinet.com.

7See SEC Release No. 34-67411, available at http://www.sec.gov/rules/sro/nasdaq/2012/34-67411.

pdf. The proposals call for DMMs to match the best existing quotes at certain times, and thus are

less aggressive than the obligations considered here.

8See SEC Release No. 34-67411, page 58.

Market Making Contracts, Firm Value, and the IPO Decision 1999

Our model shows that insufficient liquidity in competitive secondary mar-

kets can lead to complete market failure, where the firm chooses not to conduct

the IPO even though social welfare would be enhanced by doing so, or par-

tial market failure, where the IPO is completed at a price that is discounted

to reflect the fact that secondary market illiquidity will dissuade some effi-

cient trading. We show that a DMM contract, where the firm pays a market

maker a fixed fee in exchange for narrowing the bid-ask spread can cure these

market failures. Such a contract reduces market-maker trading profits and/or

imposes expected trading losses, but also increases the equilibrium IPO price,

as investors take into account the benefits of being able to subsequently trade

at lower cost. Notably, the increase in the IPO price can exceed the requisite

payment to compensate the DMM, thereby increasing the firm’s net proceeds.

The DMM contract thus represents a potential market solution to a potential

market failure.

In our model, as in the classic analysis of Glosten and Milgrom (1985),

illiquidity is attributable to information asymmetry. A key point of perspective

is that, while informational losses entail a private cost to liquidity suppliers,

these are zero-sum transfers rather than a cost when aggregated across all

agents. Competitive bid-ask spreads compensate liquidity suppliers for their

private losses to better-informed traders, and are therefore wider than the net

social cost of completing trades. A maximum spread rule can improve social wel-

fare and firm value because more investors choose to trade when the spread is

narrower. This increased trading enhances allocative efficiency and firm value.

The model generates cross-sectional predictions. First, it implies that the

efficacy of DMM contracts depends on the interaction of uncertainty and asym-

metric information regarding the fundamental value of the firm’s assets. In

the absence of asymmetric information, competitive liquidity provision is op-

timal, regardless of the degree of uncertainty regarding underlying value. In

contrast, the combination of a high probability of information asymmetry and

high uncertainty regarding fundamental value leads to potential market fail-

ure, and to improved firm value and social welfare from a DMM agreement.

This combination is likely to be particularly relevant for smaller, younger, and

growth-oriented firms. Further, the model implies that reductions in liquidity

that are attributable to real or perceived increases in information asymme-

try are economically inefficient, providing economic justification for a contrac-

tual requirement to enhance liquidity at times of high perceived information

asymmetry.

The model also has regulatory implications. If the market for liquidity pro-

vision is competitive, then contracts that require further narrowing of bid-ask

spreads will impose expected trading losses on and require side payments to

the DMM. A regulatory requirement that certain liquidity suppliers provide

liquidity beyond competitive levels without compensation could lead to exit

from the industry and ultimately be counterproductive to the goal of enhanc-

ing liquidity.

Our analysis is also relevant to regulatory initiatives related to the minimum

price increment. The U.S. Congress recently directed the SEC to reassess the