Conference Agenda

Stock markets in emerging economies often suffer from illiquidity, with prolonged intraday periods of wide bid-ask spreads and low trading. We show that public policy can boost trading by incentivizing liquidity provision through designated market makers (DMMs). Using a Chilean reform that offered tax benefits to firms hiring DMMs, we identify a causal link between DMM adoption and improved liquidity, reflected in significantly narrower bid-ask spreads. Our novel analysis of intraday spread distributions shows that about half of the spread reduction comes from DMM obligations, and the rest from spillovers to voluntary liquidity providers. The initial narrowing increased trading volume, which may have further reduced spreads through a multiplier effect. A preliminary cost-benefit analysis suggests the regulation’s benefits plausibly outweigh its fiscal costs.

We develop a model of market making and demonstrate that the effect of transparency on liquidity depends on both the cost of dealer inventory and the degree of adverse selection. With a high inventory cost and low adverse selection, which we argue describes the current market, transparency shifts more trades into the (uncertain) agency protocol and increases the bid-offer of principal trades that are hard to “match”. We test these predictions with a novel database of European corporate bond transactions, exploiting two sources of exogenous variation in transparency. Transparency increases transaction costs and the use of agency trading for large trades and trades in older bonds.

Short sellers are widely known to be informed, which would typically suggest that they demand liquidity. We obtain comprehensive transaction-level data to decompose daily short volume into liquidity-demanding and liquidity-supplying components. Contrary to conventional wisdom, we show that the most informed short sellers are actually liquidity suppliers, not liquidity demanders. They are particularly informative about future returns on news days and trade on prominent cross-sectional return anomalies. Our analysis suggests that market making and opportunistic risk-bearing are unlikely to explain these findings. Instead, our results align with recent market microstructure theory, pointing to strategic liquidity provision by informed traders.