Designating market maker behaviour in Limit Order Book markets

TL;DR

This paper proposes a new approach to defining market maker obligations in limit order book markets by incorporating liquidity replenishment speed using the Threshold Exceedance Duration metric, supported by regression modeling.

Contribution

It introduces a novel framework for market maker designations that accounts for liquidity replenishment speed, enhancing existing quoting requirement policies.

Findings

Regression models effectively relate TED to LOB state variables

Proposed approach helps set targeted liquidity replenishment levels

Incentivizes faster liquidity provision by designated market makers

Abstract

Financial exchanges provide incentives for limit order book (LOB) liquidity provision to certain market participants, termed designated market makers or designated sponsors. While quoting requirements typically enforce the activity of these participants for a certain portion of the day, we argue that liquidity demand throughout the trading day is far from uniformly distributed, and thus this liquidity provision may not be calibrated to the demand. We propose that quoting obligations also include requirements about the speed of liquidity replenishment, and we recommend use of the Threshold Exceedance Duration (TED) for this purpose. We present a comprehensive regression modelling approach using GLM and GAMLSS models to relate the TED to the state of the LOB and identify the regression structures that are best suited to modelling the TED. Such an approach can be used by exchanges to set target levels of liquidity replenishment for designated market makers.