Liquidity and Skill: Evidence from the Expulsion of Jewish Market Makers during WWII

Abstract:

On May 1, 1941, the German occupation authorities suddenly and unexpectedly banned all Jewish market makers from the Amsterdam stock exchange. We examine the effect of their expulsion on market liquidity and efficiency. In a difference-in-difference framework, we find that trading frequency dropped and price impact increased. This suggests that individual skill was crucial in reducing adverse selection. Effects were limited to securities with a single market maker, where the ban caused a complete loss of specialized skill. They were also strongest for securities most sensitive to adverse selection. Liquidity returned to normal after a period of approximately five weeks. Other market makers acquired security-specific expertise, but took time to do so. As market makers were reallocated, market efficiency declined: both the securities with a single or multiple market makers saw an increase in return reversals, suggesting a general decline in market makers’ ability to provide liquidity and absorb order book imbalances.