The role of market makers in hybrid markets

We propose a model in which a market maker interacts with strategic traders and market order traders to examine the role of market makers in hybrid markets. In our model, the market maker acts as both a liquidity provider and a liquidity consumer, distinguishing her role from that in a quote-driven market. We demonstrate that market makers contribute to stock liquidity in hybrid markets characterized by a high probability of asset value jumps or a low arrival rate of market order traders. This effect arises as market makers continuously place limit orders at wide spreads in the limit-order book, creating a “channel effect” that constrains the spreads of strategic traders’ orders. To provide empirical support for the theoretical results, we exploit a quasi-natural experiment related to the introduction of a market maker mechanism on China’s Sci-Tech Innovation Board (STAR Market). Our results show strong alignment between the empirical evidence and the model’s predictions. Moreover, our model indicates that while reducing market makers’ mandated spread can enhance the channel effect and further improve stock liquidity, excessively narrowing the spread may erode market makers’ profitability, potentially prompting their exit from the market. • A novel model is proposed to clarify market makers’ interaction with other traders in hybrid markets. • Market makers act as both liquidity providers and consumers in hybrid markets. • The model introduces a “channel effect” to illustrate how market makers influence stock liquidity.