In Good Times and in Bad : High-Frequency Market Making Design, Liquidity, and Asset Prices

How can exchanges and regulators improve the liquidity and stability of modern financial markets through liquidity provision obligations and incentives? We exploit two market maker programs as natural experiments using unique message-level trade and quote data from the Brazilian stock exchange that reveal market participants’ identities. We find combining obligations and incentives improves and stabilizes liquidity which attracts volume and lifts asset prices. In normal times, these positive effects are driven by the program incentives, while tight obligations constrain market makers and decrease market quality. In crises, however, the results flip: voluntary liquidity providers withdraw which exacerbates liquidity dry-ups; in contrast, tight obligations force market makers to step in as liquidity providers of last resort which mitigates liquidity dry-ups. This liquidity backstop can generate a Pareto improvement: even the forced liquidity providers do not incur losses. Overall, our results suggest to combine incentives with countercyclical liquidity provision obligations