The contribution of market makers to liquidity and efficiency of options trading in electronic markets

This paper examines the contribution of market makers to the liquidity and the efficiency of the options market in a unique setup of an order-driven computerized trading system, in which market makers and other participants operate under equitable conditions. The main findings are: (1) liquidity increased - a 60% increase in trading volume and a 35% decrease of bid-ask spreads,- (2) the efficiency of shekel-euro options trading improved - deviations from put-call parity decreased significantly by 12%, and skewness decreased by about 30%. We also find that the net cost to the exchange is out weighted by the benefit to the trading public and that the presence of market makers encouraged trading between other participants far beyond their own trading. (c) 2005 Elsevier B.V. All rights reserved.