Large-caps liquidity provision, market liquidity and high-frequency market makers’ trading behaviour

Abstract

This paper exploits the introduction of the liquidity provision scheme (LPS) in NASDAQ Stockholm (NOMX) to assess how the implementation of LPS affects market liquidity and the trading behaviors of high-frequency market makers. Unlike the traditional designated market makers (DMM) that target the liquidity supply of small and less traded stocks, LPS is implemented for large-caps and liquid stocks. LPS requires participants to submit buy and sell orders at the European best bid and offer quotes with a size larger than 50,000 Swedish Krona on each trade side. LPS delivers liquidity improvements by reducing order processing costs in the large-cap and cross-listed stocks in the NOMX and Chi-X markets, with no evidence of market liquidity migration from Chi-X to NOMX. As market makers registered with LPS are likely high-frequency traders, LPS stabilizes market liquidity as market makers’ decisions to supply or demand liquidity become less sensitive to market conditions like the spread and order imbalance.

KEYWORDS:

• Market maker
• market design
• trading behavior
• liquidity provision

Acknowledgement

We would like to thank Lars Nordén, Björn Hagströmer and Petter Dahlström for their support and numerous discussions about the market structure and the paper. Valuable comments were also received from Dagfinn Rime, Bernt Arne Ødegaard, Joakim Westerholm, Ming-Hung Wu, the participants at Stockholm Business School seminar, Auckland Finance Meeting and Conference on the Theories and Practices of Securities and Financial Markets in Taiwan. We also thank two referees and the Associate Editor for their valuable comments which improve the overall quality of the paper. Any remaining errors are our own.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 This scheme conforms to the European Union (EU) law set out in the Markets in Financial Instruments Directive (MiFID) aimed at harmonizing regulations for investment services across member states to harness the competitiveness of EU financial markets.

2 Outside the NOMX, the OMXS30 stocks are also traded on several other trading venues, including Chi-X, BATS, Turquoise and Burgundy.

3 The average daily trading volume for the OMXS30 stocks is approximately 10.7 billion SEK during the month before the LPS introduction. The fall in spread translates to 10.7 (billion)*1.74 (bp) ≈ 1.86 million fall in trading costs. The average exchange rate between the Swedish Krona and US Dollar in 2012 is taken as SEK/USD = 0.147.

4 The three market makers are: Merrill Lynch International, Spire Europe Ltd and GETCO Europe Ltd. The latter two market makers are considered as high frequency traders.

5 The European best bid (offer) quote is the highest (lowest) buy (sell) price amongst NOMX, BATS, Chi-X, Burgundy and Turquoise exchanges.

6 In contrast, DMMs in NOMX firms can contract directly with DMMs to provide liquidity to their stocks. Such activities are not necessarily done through a designated algorithmic trading account.

7 Li, Wang, and Ye (2021) argue that algorithmic traders in some cases use more aggressive orders than HFT to supply liquidity because their opportunity cost is lower than HFT. The conditions when algorithmic traders can out-price HFT are set by how discrete the prices are (whether the tick-size is binding).

8 The LPS account is an algorithmic trading account, which the NOMX defines as a platform ‘where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention'.

9 The DMM we compare LPS to is for the traditional DMM which differs from the NYSE DMM program discussed in Bessembinder, Hao, and Zheng (2020). The NYSE DMM program was adopted in 2008, with NYSE assigning one firm to act as DMM in every listed security. The traditional DMM is targeted for small and illiquid stocks, and it is the listed firm who hires DMM.

10 Both liquidity-demanding and liquidity-supplying transactions of these qualified LPS participants are subject to the reduced fees. For the maker (liquidity-supplying) transactions, the fee is 0 basis points while the taker (liquidity-demanding) transactions, the fee is 0.5 basis points.

11 Market makers in practice typically avoid taking large one-sided position, or large inventory for a long period of time to limit their exposure to market risk.

12 Based on the 5-min intraday data from year 2012 to 2016 on the large -cap stocks in the NOMX, the average 5-min quoted spread is 30 bps and 34 bps in March and June, respectively. The average 5-min trading volume in MSEK is 1.08 and 1.00 in March and June, respectively.

13 In Kim and Murphy (2013), the daily effective spread for each stock is calculated as $\frac{1}{M_d}\sum _{t=1}^{M_d}2\ast |p_t-mi{d}_t-{\mu }_t|$ $=\frac{1}{M_d}\sum _{t=1}^{M_d}2\ast |c_0{q}_t+c_1{x}_t+z_0\widetilde{q_t}+z_1\widetilde{x_t}|$, where $mi{d}_t$ is the prevailing bid-ask midpoint, and ${\mu }_t$ is the innovation from equation (9).

14 $AbsoluteInventory=|Buy-Sell|,$and$RelativeInventory=|Buy-Sell|/\left(Buy+Sell\right)$, where Buy (Sell) is the number of shares purchased (sold).

15 The trader MPID and member names are available at http://www.nasdaqomx.com/transactions/markets/nordic/membership/membership-lists accessed in September 2021.

16 The European Principal Traders Association was established in June 2011 to represent principal trading firms, i.e., firms that trade with their own capital.

17 GEL was merged into KCG in 2013. See https://www.sec.gov/Archives/edgar/data/1060749/000119312512508185/d455870d425.htm, accessed in September 2021.

18 $Imbalanc{e}_{s,t}=side\ast \frac{bidsiz{e}_{s,t}-asksiz{e}_{s,t}}{bidsiz{e}_{s,t}+asksiz{e}_{s,t}}$, where $bidsiz{e}_{s,t}$($asksiz{e}_{s,t}$) is the SEK volume available at the best bid (ask) quote immediately before the aggregated trade for stock s and time t.$side$ is equal to 1 for liquidity-supplying buyer and liquidity-demanding buyer regressions, and -1 for liquidity-supplying seller and liquidity-demanding seller regressions.

19 It is possible that traders use large marketable limit orders that are executed at several prices, so-called walk the book trades. If market makers submit more limit orders deep in the book when the volatility increases, we would expect a positive ${\gamma }_3$ for walk the book trades. However, walk the book trades are relatively uncommon. Hagströmer, Nordén, and Zhang (2014) document that less than 0.05% of the order messages are walk the book trades for the OMXS30 stocks.

20 For details on various LP programs in the Nordic countries, refer to the URL: https://www.nasdaq.com/solutions/liquidity-enhancement#:∼:text=In%20a%20Liquidity%20Provider%20Program,of%20the%20missing%20desired%20investor.