Paying for Market Quality

Many financial markets, including electronic limit order markets, assign designated liquidity providers (LPs). We study the experience of the Stockholm Stock Exchange, where listed firms contract directly with LPs. Our analysis offers insights regarding situations where designated liquidity provision may be beneficial. In addition, we consider the form of liquidity provision contracts, including affirmative obligations required of the LP and compensation for LP services. We find that low current trading activity, wide spreads, and higher information asymmetry increase the attractiveness of contracted liquidity provision. The evidence indicates that LPs trade against market movements and in times of wide spreads. On balance, firms contracting with LPs experience a decreased cost of capital and significant improvements in market quality and price discovery.