Essays on Institutional Trading and Liquidity

Abstract

This dissertation shines light on financial market liquidity from both sides: its supply by market makers and its demand by investors. Chapter 1, co-authored with Pedro Tremacoldi-Rossi, investigates how exchanges and regulators can 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 incentives, while tight obligations constrain market makers and decrease market quality. In crises, however, the results flip: stocks with larger incentives experience worse liquidity dry-ups because voluntary liquidity providers withdraw; in contrast, tight obligations mitigate liquidity dry-ups because mandatory intermediaries step in as the liquidity providers of last resort. Overall, our results suggest exchanges and regulators should combine incentives with countercyclical liquidity provision obligations. Chapter 2 proposes a new method to isolate a plausibly exogenous component of mutual fund flows to estimate the price impact of fire sales. The method addresses a potential reverse causality problem: instead of mutual fund outflows inducing fire sales, which drive down prices, poor stock returns reduce mutual fund returns, which in turn trigger outflows. The solution is to construct a new instrument from high-frequency surprise flows. Using surprise flows, I find equity markets are deeper than previously suggested. Chapter 3 uses the reinvestment of corporate payouts by financial institutions as a nonfundamental shock to asset prices to estimate the slope of the demand curve for stocks and the real effects of stock returns on corporate financing and investment. I find dividends in particular generate payment date price pressure but no announcement date news spillover effects, suggesting that dividend-induced trading is plausibly exogenous to fundamentals. Using this natural experiment, I provide a new asset demand elasticity estimate and document a releveraging market feedback effect: firms respond to an exogenous stock price increase by issuing debt and use the funds to invest.