Which firms benefit from market making?

There are two primary methods of trading shares (i.e., order processing) in the US. The New York Stock Exchange (NYSE) uses a continuous auction method that is augmented by a designated liquidity provider and the National Association of Securities Dealers Automated Quotations (NASDAQ) uses a market-maker method. Because, as in most markets the trading methods are specific to the exchanges and the exchanges differ in other ways, it is difficult to study the implications of a firm’s choice of trading method.

From December 1, 1998 until March 21, 2008, all firms on the Japan Association of Securities Dealers Automated Quotations (JASDAQ) exchange could choose and switch between a market maker method similar to NASDAQ and a continuous auction method similar to NYSE for trading their shares. For the sample period, we obtain data from JASDAQ on listed firm selections of market making or auction and on the timing of switches between market making and auction. Bid-ask spreads, and other microstructure information are from the Nikkei Portfolio Master (NPM) data of Financial Data Solutions, Inc. We compute the market return as the equal-weighted average of returns computed using daily closing price and trading volume for all listed firms on Japanese stock exchanges obtained from the Nikkei Economic Electronic Database System (NEEDS) data.

We find that selecting a more suitable trading method increases firm value. When smaller firms switched to market making, their liquidity improved; while larger firms switched to auction despite modest but significant decreases in liquidity. The results suggest that, though market making is costly, it is valuable for firms as long as the liquidity benefits are sufficient to justify the implicit intermediation fee.

Our study adds to the literature in two main respects. First, the JASDAQ experiment provides a unique opportunity to compare firms’ choices of switching between an auction-based system and a market-maker-based system without encountering the other differences associated with exchanges. Second, we focus on how a firm’s trading method choice is associated with firm value. In contrast to studies that only observe the relationship between trading method and stock liquidity, we study the connections of trading method change to liquidity and market value changes.