Why do firms pay for liquidity provision in limit order markets?

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1 Why do firms pay for liquidity provision in limit order markets? Johannes Skjeltorp a Bernt Arne Ødegaard b,a April 2010 a: Norges Bank b: University of Stavanger

2 Problem Oslo Stock Exchange Electronic Limit order market Liquidity provided by orders from market participants (only) Designated Market Maker (DMM) Listed firms pay financial intermediary (DMM) to maintain an orderly market in the firms stock. Question in this paper Why are listed firms willing pay for the improved liquidity provided by the DMM?

financial intermediary (DMM) to maintain an orderly market in the firms stock.

3 Why is this not an obvious (and trivial) question? Prior research: When firms hire a DMM, liquidity improves. But that is what the DMM is paid to do. We ask: From a corporate finance perspective, why would a listed firm pay for liquidity? Firm already paid cost of becoming listed, making the stock available to investors. Why pay more? Possible explanations: From the perspective of the owner of a stock, improved liquidity increases value of owning stock. But not clear this is relevant for the firm, why should they subsidize the owners that want to sell the firm s stock. The firm already has the capital. Rather: More plausible economic reason: Liquidity in the stock only matters to the stock s issuer when directly interacting with the capital market Issue more stock Repurchase stock Issue debt..

Possible explanations: From the perspective of the owner of a stock, improved liquidity increases value of owning stock.

4 Summarizing the paper We ask Is the firm s decision to pay for DMM services related to the probability of the firm interacting with the stock market? We do We use data from the DMM deals at the Oslo Stock Exchange to empirically investigate the question. We show Liquidity improves after the DMM deal DMM hirers are more likely to need new capital. Capital needs proxied by: DMM hiring firms are better (higher Q) They issue equity within a year after the DMM deal.

We do We use data from the DMM deals at the Oslo Stock Exchange to empirically investigate the question.

5 Prior literature Two Strands: Market microstructure The interaction of liquidity and corporate finance

6 Prior literature, ctd Market microstructure Early theoretical literature, e.g. [Glosten and Milgrom, 1985, Kyle, 1985], discuss role of market maker. Empirically, exchanges move away from market makers. Theoretically, inevitability of limit order markets [Glosten, 1994]. Empirically, limit order markets (Paris, Frankfurt, Stochkolm, Oslo...) reintroduce market makers for selected stocks. (Designated Market Makers DMM) Evolving microstructure literature Theoretically what are the potential roles for a market maker in limit order markets (e.g. Anand and Subrahmanyam [2008].) Information production? Empirically what have been the effects of DMM introductions?

Empirically, limit order markets (Paris, Frankfurt, Stochkolm, Oslo...) reintroduce market makers for selected stocks.

7 Prior literature, ctd Studies of DMM initiations Anand, Tangaard, and Weaver [2008] Stockholm Hengelbrock [2008] Deutsche Borse Menkveld and Wang [2010] EuroNext Venkataraman and Waisburd [2007] Paris Typically find Liquidity improves after the introduction of a DMM. One or at the most two DMMs is enough, more does not improve liquidity. The stock market views the hiring of DMMs as a positive signal

Paris Typically find Liquidity improves after the introduction of a DMM.

8 Prior literature, ctd An evolving literature studies the link between stock liquidity and corporate finance. Some examples Easley and O Hara [2004] Link information production (liquidity) to cost of capital. Lipson and Mortal [2009] Better stock market liquidity lower cost of equity. Brockman, Howe, and Mortal [2008] Stock market liquidity affect repurchase decisions Mantecon and Poon [2009] Desired liquidity affect IPO decisions. Most of this literature treats liquidity as an exogenous property of the stock.

Lipson and Mortal [2009] Better stock market liquidity lower cost of equity.

9 Our innovation relative to the literature By hiring a DMM, liquidity can be directly influenced by the firm that has issued the stock. We treat the hiring of Designated Market Makers as endogenous decisions, and ask: What influences this decision?

10 Equity trading at OSE Electronic limit order market, main market for trading of Norwegian stocks, although also other trading venues. A Designated Market Maker is a contract between a financial intermediary and issuing firms. The intermediary is paid an undisclosed amount to maintain an orderly market The DMM obligations in the standard contract: bid and ask quotes should be available at least 85% of the trading day. The minimum volume at both the bid and ask quotes should equal 4 lots. The relative spread should not exceed 4%.

The intermediary is paid an undisclosed amount to maintain an orderly market The DMM obligations in the standard contract: bid and

11 Describing DMM deals at the OSE Total active stocks at OSE New DMM contracts Active DMM contracts of which in firm size quartile of which in firm size quartile

13 16 13 3 Active DMM contracts 5 28 37 45 54 44 of which in firm

12 What is the effect on the market of hiring a DMM? 1. Does liquidity improve? 2. Does the market react?

13 Does liquidity improve? Liquidity measures before and after market maker deals Period before Period after t-test diff 1 year 6 months 6 months one year 6 months 1 year Rel Spread (0.00) (0.00) LOT (0.00) (0.32) Amihud (0.00) (0.01) Monthly Turnover (0.25) 0.01 (0.03) ( Low tech liquidity measures, from daily data ) Relative spread LOT: # non trading days ILR: Amihuds measure, elasticity of price Turnover: Trading volume measure

year Rel Spread 0.037 0.038 0.024 0.025-0.01 (0.00) -0.01 (0.00) LOT 0.041 0.040 0.033 0.038-0.01 (0.00) -0.00 (0.32) Amihud 0.524 0.568 0.

14 Market reaction to DMM introduction Event study, centered at date of DMM introduction Event study CAR lag (Straight excess returns)

035 Event study 0.03 0.025 0.02 CAR 0.015 0.01 0.

15 What is the effect on the market of hiring a DMM? Summarizing results: 1. Liquidity improves 2. The market react positively

16 Analyzing decision to hire DMM Object of interest: Firm s decision to hire DMM to improve liquidity of the stock. What affects this? Decision theoretic empirical analysis (Logit/Probit). Determinants of the decision: Likelihood of issuing capital (our hypothesis) Growth potential (Q) Ex post decision to raise equity capital Likelihood of repurchasing (alternative reason for hiring DMM). Actually repurchase next year. Liquidity measure (control). Only want to hire DMM is liquidity is low. Firm size (control) only small firms hire DMM Either use firm size as a control or only do analysis for small firms.

Determinants of the decision: Likelihood of issuing capital (our hypothesis) Growth potential (Q) Ex post decision to raise equity capital Likelihood of

17 Logit analysis, decision to hire DMM Proxy for probability of issuing capital: Tobin s Q (ex ante) Variable coeff pvalue liquidity last year (spread) (0.07) ln(firm size) (0.00) q last year 0.19 (0.00) repurchase within a year 0.67 (0.01) constant 5.58 (0.00) n 1156 Pseudo R

(spread) -0.09 (0.07) ln(firm size) -0.45 (0.00) q last year 0.19 (0.

18 Logit analysis, decision to hire DMM Proxy for probability of issuing capital: Actual capital issue (ex post) Variable coeff pvalue liquidity last year (spread) (0.02) ln(firm size) (0.00) issue capital within a year (0.81) repurchase within a year 0.69 (0.01) constant 5.21 (0.00) n 1156 Pseudo R

(spread) -0.13 (0.02) ln(firm size) -0.41 (0.00) issue capital within a year -0.

19 Decision to hire or keep a DMM Each year a new decision: If the stock doesn t have a DMM hire one. If the stock has a DMM keep it. In the decision theoretic analysis: View either as the DMM decision

20 Logit analysis, decision to hire or keep DMM Proxy for probability of issuing capital: Tobin s Q (ex ante) Variable coeff pvalue liquidity last year (spread) (0.07) ln(firm size) (0.00) q last year 0.19 (0.00) repurchase within a year 0.67 (0.01) constant 5.58 (0.00) n 1156 Pseudo R

year (spread) -0.09 (0.07) ln(firm size) -0.45 (0.00) q last year 0.19 (0.

21 Logit analysis, decision to hire or keep DMM Proxy for probability of issuing capital: Actual capital issue (ex post) Variable coeff pvalue liquidity last year (spread) (0.02) ln(firm size) (0.00) issue capital within a year (0.81) repurchase within a year 0.69 (0.01) constant 5.21 (0.00) n 1156 Pseudo R

22 Concluding decision theoretic analysis Measures of probability of interacting with capital markets issuing capital repurchase are important for the decision to hire a DMM.

23 Concluding decision theoretic analysis Measures of probability of issuing capital are important for the decision to hire a DMM.

24 Conclusion Our empirical results points to: For listed firms, liquidity matters in the secondary market of the firms stock mainly matters to the firm because of the market s role when new capital is raised. Firms are willing to pay to improve liquidity when they expect to use the stock market to raise capital

25 Appendix: Extra results

26 Logit analysis, decision to hire DMM Tobin s Q as a proxy for probability of issuing capital Variable coeff pvalue liquidity last year (spread) (0.17) q last year 0.28 (0.00) repurchase within a year 0.58 (0.05) constant (0.00) n 525 Pseudo R

27 Logit analysis, decision to hire DMM Variable coeff pvalue liquidity last year (spread) (0.04) issue capital within a year 0.24 (0.43) repurchase within a year 0.73 (0.01) constant (0.00) n 525 Pseudo R

28 Amber Anand and Avindhar Subrahmanyam. Information and the intermediary: Are market intermediaries informed traders in electronic markets. Journal of Financial and Quantitative Analysis, 43(1):1 28, March Amber Anand, Carsten Tangaard, and Daniel G Weaver. Paying for market quality. Journal of Financial and Quantitative Analysis, forthcoming. Paul Brockman, John S. Howe, and Sandra Mortal. Stock market liquidity and the decision to repurchase. Journal of Corporate Finance, 14: , Devid Easley and Maureen O Hara. Information and the cost of capital. The Journal of Finance, 59: , L Glosten. Is the electronic limit order book inevitable? Journal of Finance, 49: , L Glosten and P Milgrom. Bid, ask and transaction prices in a specialist market with heterogenously informed traders. Journal of Financial Economics, 14:71 100, March Jördis Hengelbrock. Designated Sponsors and Bid-Ask Spreads on Xetra

29 Albert Kyle. Continous auctions and insider trading. Econometrica, 53: , Marc L. Lipson and Sandra Mortal. Liquidity and capital structure. Journal of Financial Markets, 12, doi: doi: /j.finmar Tomas Mantecon and Percy Poon. An analysis of the liquidity benefits provided by secondary markets. Journal of Banking and Finance, 33: , Albert J Menkveld and Ting Wang. How do designated market makers create value for small-caps? Working Paper, Tinbergen Institute, February Kumar Venkataraman and Andrew C Waisburd. The value of the designated market maker. Journal of Financial and Quantitative Analysis, 42(3): , September 2007.

The (implicit) cost of equity trading at the Oslo Stock Exchange. What does the data tell us?

The (implicit) cost of equity trading at the Oslo Stock Exchange. What does the data tell us? Bernt Arne Ødegaard Sep 2008 Abstract We empirically investigate the costs of trading equity at the Oslo Stock