Stock-Based Pay, Liquidity, and the Role of Market Making

We study the role of trading, and in particular market making, for the provision of stock-based incentives to managers. Market making provides liquidity as it allows trading on private information about the value of the firm. But in a liquid market the stock price does not react much to the order flow, including the order flow of informed traders. Market making therefore makes it more difficult to detect shirking and to provide stock-based incentives. Our model provides novel comparative statics, e.g., the manager may receive more stock-based pay when traders' information becomes worse, clarifies the role of public information such as accounting numbers as an additional performance measure, and shows that economic efficiency can be independent of stock-market efficiency because the optimal incentive contract adjusts to market conditions