Market Maker Revenues and Stock Market Liquidity

We use an 11-year panel of daily specialist revenues on individual NYSE stocks to explore the relationship between market-maker revenues and liquidity. If market makers suffer substantial trading losses, lenders may respond by increasing funding costs or reducing credit lines, and market makers should respond by reducing liquidity provision. The data indicate that when specialists in aggregate lose money on their inventories, market-wide effective spreads widen in the days or weeks that follow, even after controlling for stock returns, volatility, and volume. This suggests an important role for market-maker financial performance in explaining liquidity time-variation. Revenues at the specialist firm level explain liquidity changes in that firm's assigned stocks. Revenues at the individual stock level do not explain changes in individual stock liquidity, consistent with a financial constraints model with broadly diversified intermediaries. Aggregate specialist revenues are increasing in conditional return volatility, as is revenue volatility. Specialist margins (specialist revenue per dollar of trading volume) are essentially constant across stocks, implying limited scope for cross-subsidization