Stock markets in emerging economies often suffer from severe illiquidity. We show that public policy can improve trading conditions by incentivizing designated market makers (DMMs). Exploiting a Chilean tax reform, we identify a causal link between DMM adoption and sharply narrower bid–ask spreads. A novel analysis of intraday spread distributions shows that half of the improvement stem from spillovers to other liquidity providers. These spillovers reflect a virtuous cycle: tighter spreads attract higher trading volume, lowering average operating costs of liquidity suppliers and enabling further spread tightening. Economies of scale in liquidity provision seem crucial in illiquid markets.