Market Microstructure in Emerging and Developed Markets

CHAPTER 14

Market Makers and Liquidity

FRANK J. SENSENBRENNER

Visiting Fellow, Johns Hopkins SAIS, Center for Transatlantic Relations

INTRODUCTION

This chapter examines the role of market makers and market structures in asset markets. It begins with a review of how asset markets in each trading class operate and explains the role of a market maker or similar intermediary in the behavior of each market. A key function of a market is to determine a fair value for the instrument traded and to provide buyers and sellers with an opportunity to exchange their property. Economists call the ability to trade liquidity, which Warsh (2007), a former Federal Reserve Bank governor, views as the ability to transform one asset into another without loss of value. Academics have sought to identify and quantify traits that can be used to measure how much liquidity exists in a marketplace. Kyle (1985) measures liquidity in three ways: (1) tightness, as measured by the bid-ask spread; (2) depth, as indicated by the volume of securities available for trading in the market; and (3) resiliency, as measured by the speed at which prices revert to normal after a sizable trade. Therefore, in order to trade, the capacity of a market to have liquidity is essential. One mechanism exchanges use to ensure liquidity is to set up a system where certain parties have the responsibility to provide liquidity. These parties are known as market makers.

Market makers originated on both the New York Stock Exchange (NYSE) ...