Time Variation in Liquidity: The Role of Market‐Maker Inventories and Revenues

Abstract

We show that market-maker balance sheet and income statement variables explain time variation in liquidity, suggesting liquidity-supplier financing constraints matter. Using 11 years of NYSE specialist inventory positions and trading revenues, we find that aggregate market-level and specialist firm-level spreads widen when specialists have large positions or lose money. The effects are nonlinear and most prominent when inventories are big or trading results have been particularly poor. These sensitivities are smaller after specialist firm mergers, consistent with deep pockets easing financing constraints. Finally, compared to low volatility stocks, the liquidity of high volatility stocks is more sensitive to inventories and losses.ASSET MARKET LIQUIDITY VARIES considerably over time. This variation matters to market participants who worry about the cost of trading into or out of a desired position in a short period of time. Liquidity can affect asset prices, too. For example, investors may demand higher rates of return as compensation for holding illiquid assets and assets that are particularly sensitive to fluctuations in liquidity. However, despite the interest in aggregate liquidity from both of these angles, we know relatively little about exactly why market liquidity varies over time. Recent theoretical work by Gromb and Vayanos (2002) and Brunnermeier and Pedersen (2009), among others, postulates that limited market-maker capital can explain empirical features of asset market liquidity.

Explaining co-movements between equity and CDS bid-ask spreads

“…In a crisis period, financial constraints and extreme volatility risk may give rise to the forced withdrawal of liquidity in several markets simultaneously, often accompanied by fire-sales of assets. Comerton-Forde et al (2010), Hameed et al (2010), and Ben-David et al (2012), amongst others, provide empirical evidence for this theory in equity markets. However, no study has tested yet this mechanism (which I call 'funding channel') for the co-movements between equity and CDS bidask spreads, as my paper instead does.…”

Market Making, Liquidity Provision, and Attention Constraints: An Experimental Study

“…18 [43] finds that lagged NYSE specialist inventories and trading revenues predict market liquidity. According to their study, specialists usually earn positive trading revenue on intraday round-trip transactions but are more exposed to the possibility of losses on inventories held for longer periods such as overnight.…”

“…One market has four uninformed traders while the other has only two un-informed traders. 43 In one block of 10 trials, each market maker is required to participate in only one market (i.e. low attention constraints environment).…”

Aggressive and Defensive High-Frequency Trading and its Impact on Liquidity of German Stock Market

“…The confirmation of relationship between spreads and market makers activity brought first significant results. Specialist firmlevel spreads are getting wider when specialists hold large positions or loose money (Comerton-Forde, 2010). Co-movement of liquidity is stronger among stocks listed on NYSE, which are traded by the same specialist company (Coughenour 2004).…”