When Do Listed Firms Pay for Market Making in Their Own Stock?

• Date: 01 June 2015
• Author: Bernt Arne Ødegaard,Johannes Atle Skjeltorp
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/fima.12058

When Do Listed Firms Pay for Market

Making in Their Own Stock?

Johannes Atle Skjeltorp and Bernt Arne Ødegaard∗

A recent innovation in the equity marketsis the introduction of market maker services procured by

the listed companies themselves. Using data from the Oslo Stock Exchange, we investigate what

motivates issuing firms to pay to improve the secondary market liquidity of their listed shares.By

examining the timing of market maker hirings relative to corporate events, we show that hirings

are morelikely when the firm will interact with the capital markets in the near future. Futhermore,

a typical firm employing a designated market maker is more likely to raise capital, repurchase

shares, or experience an exit by insiders.

On March 20, 2013, the NASDAQ Stock Market LLC (hereafter “NASDAQ”) receivedapproval

from the Securities and Exchange Commission (SEC) to establish a market quality program

(MQP).1This program allows companies to pay financial intermediaries directly for market

making services.2NASDAQ claims that the prime beneficiaries of the new program are the

listed companies.3More specifically, they argue that their MQP will “lower transaction costs and

enhance liquidity,” which will “help companies access capital to invest and grow.” NASDAQ

also quotes Congressman Patrick McHenry who argues that paying for market making activity

“...would allow small companies to produce an orderly, liquid market for their stocks.” Thus,

through what is typically called a designated marketmaker (DMM) program, the f irms themselves

can affect the nature of trading in their stock.

Understanding the mechanisms and effects associated with DMM programs will provide valu-

able input to policy makers and regulators in the United States. This is particularly important

since the NASDAQ initiative may pave the way for a more general introduction of MQPs. Due

to the obvious lack of US data on DMMs, one needs to look to other markets that already have

similar programs in place. In this paper, we examine all DMM arrangements at the Oslo Stock

We would like to thank Vegard Anweiler and Thomas Borchgrevink at the Oslo Stock Exchange for providing us with

information regarding market maker arrangements at the Oslo Stock Exchange. We are grateful for comments from an

anonymousreferee, MarcLipson (Editor), Gorm Kipperberg, Randi Naes, Elvira Sojli, Carsten Tangaard,Wing WahTham,

Siri Valseth,Arne Tobias Malkenes Ødegaard,participants at the FIBE 2010, AFFI 2010, Arne Ryde 2011 Workshop,EFA

Conference 2011, the 9th International ParisFinance Meeting 2011, the 2012 Nordic Corporate Governance Workshop

in Reykjavik, and seminar participants at NHH, Norges Bank, NTNU, and the Universities of Mannheim and Stavanger.

The views expressed arethose of the authors and should not be interpreted as reflecting those of Norges Bank or Norges

Bank Investment Management. Any remainingerrors or omissions are ours.

∗Johannes Atle Skjeltorp is a Senior Analyst at Norges Bank Investment Management in Oslo, Norway. Bernt Arne

Ødegaard is a Professorat the University of Stavanger in Stavanger, Norway, and the Norwegian School of Economics

(NHH).

1See the FederalRegister/Vol. 78, No. 58/Tuesday, March 26, 2013/Notices.

2These payments have not been allowed thus far in the United States due to FINRA Rule 2460 (Payment for Market

Making – FINRA Regulatory Notice 09-60). In 2012, NYSE Arca proposed a similar “Lead Market Maker Program,”

but the proposal was later withdrawn. (SEC Release No. 34-66966, May11, 2012 contains the proposal).

3See NASDAQ’s initial submission to the SEC, found at http://www.sec.gov/rules/sro/nasdaq/2012/34-66765.pdf.

Financial Management •Summer 2015 •pages 241 - 266

242 Financial Management rSummer 2015

Exchange (OSE) from 2004 to 2012. In particular, we examine whether corporate decisions to

raise equity capital and repurchase shares can be linked to the timing of the hiring of DMMs.

In the 1980s and 1990s, many European markets shifted from dealer markets and call auction

systems (e.g., daily call auctions at the Paris Bourse) to continuous limit order systems without

any market makers or floor traders with special obligations to provide liquidity (Biais, Hillion,

and Spatt, 1995). Since smaller firms typically have higher levels of asymmetric information that

discourages liquidity provision, it was difficult to maintain a liquid market in the smaller stocks.

One solution was to introduce DMM programs, where listed firms are given the option to engage

in a contract with a third party who commits to provide liquidity by continuously maintaining bid

and ask quotes in the electronic limit order book. The issuing firms pay an out-of-pocket cost for

the “liquidity service,” which is paid directly to the financial intermediary providing the service.

Our analysis is motivated from two perspectives: 1) from the perspective of the market and 2)

from the perspective of the firm. From the market perspective, we can theoretically makethe case

that there is a potential “inefficiency” in the trading mechanism. Pure limit order markets rely on

liquidity provided by the traders themselves without any exchange-assigned intermediary with

affirmative obligations. In these markets, there is a potentially under-supply of liquidity in stocks

with high levels of asymmetric information. For example, in the equilibrium of the classical

Glosten and Milgrom (1985) model, a monopolistic market maker sets competitive prices such

that the expected losses to informed traders is offset by profits from trading with uninformed

(noise) traders. However, once we allow for the free entry of market makers, as in an electronic

limit order market, this equilibrium breaks down. A market maker can no longer sustain losses

to informed traders since they no longer have any guarantee of recapturing the adverse selection

costs from uninformed traders. Therefore, equilibrium spreads will need to increase, especially

for stocks with high levels of asymmetric information.

One way to restore an equilibrium with spreads similar to those of the monopolistic market

maker case would be to compensate the market maker for the expected losses to informed traders.

This is a useful way of thinking about DMM contracts. The level of the fixed fee paid by the

issuing firm must be such that it covers the DMM’sexpected losses to informed traders, allowing

the market maker to maintain a lower spread than the competitive market solution. For stocks

with high degrees of asymmetric information, the required fee would potentially be very high, as

demonstrated by Bessembinder, Hao, and Zheng (2013).

This brings us to the corporate finance perspective of the paper. Under what circumstances are

issuing firms willing to compensate a market maker? The analysis of Bessembinder et al. (2013)

provides insight into these questions. Bessembinder et al. (2013) theoretically analyze the case

where a firm considers an initial public offering (IPO), and examine how the hiring of a DMM can

improve the terms of the IPO. Bessembinder et al. (2013) show the feasibility of an equilibrium

where a firm hires a DMM to support the after-listing market liquidity of the issuing f irm’s

shares against a fee. This allows the firm to charge a higher price in their IPO. Bessembinder

et al. (2013) conclude that the DMM contract increases trading volume and enhances allocative

efficiency, price discovery, and f irm value. Their conclusion is consistent with Ellul and Pagano

(2006) who determine, both theoretically and empirically, that underpricing in an IPO is lower if

the after-issue stock is more liquid. Thus, if a firm can guarantee that a stock will be more liquid

in the future, it can support a higher IPO price today. Thus, the Bessembinder et al. (2013) model

supports the NASDAQ claim that payment for market making is in the interest of listed firms if

the under-supply of liquidity is due to asymmetric information.

While the Bessembinder et al. (2013) model specifically discusses IPO situations, it generalizes

to other cases where the liquidity of the company’s stock affects the terms of market transactions.

In these cases, firms may want to improve liquidity before they initiate the market transaction.