Do designated market makers provide liquidity during downward extreme price movements?

TL;DR

The paper investigates whether designated market makers (DMMs) fulfill their liquidity-provision mandate during downward extreme price movements by exploiting drift-burst EPM detection in BEDOFIH data for 34–37 CAC 40 stocks. Using a drift-burst statistic $T_t$ to identify downward EPMs and a VAR framework to analyze trader-category trading imbalances, it distinguishes unsystematic and systematic episodes and tracks DMM behavior relative to other market participants. The key finding is that DMMs provide liquidity when the sell-off is isolated to a single stock but tend to withdraw or even sell when the downturn spreads across multiple stocks, with slow traders (NON-HFT) often steping in as liquidity providers during systemic stress. These results imply that the current SLP-based incentive structure may be insufficient to sustain DMM liquidity during broad market distress, carrying implications for market efficiency and policy design around algorithmic liquidity provision.

Abstract

We study the trading activity of designated market makers (DMMs) in electronic markets using a unique dataset with audit-trail information on trader classification. DMMs may either adhere to their market-making agreements and offer immediacy during periods of heavy selling pressure, or they might lean-with-the-wind to profit from private information. We test these competing theories during extreme (downward) price movements, which we detect using a novel methodology. We show that DMMs provide liquidity when the selling pressure is concentrated on a single stock, but consume liquidity (leaving liquidity provision to slower traders) when several stocks are affected.

Figures (12)

• Figure 1: Trading activity by trader category
• Figure 2: The price of Technip on June 25, 2013
• Figure 3: Temporal distribution of drift burst EPMs
• Figure 4: Average cumulative return during a drift burst EPM
• Figure 5: Price impact of a drift burst EPM