Portfolio risk,adjustment costs,and security dealers' bid/ask spreads

This article notes that dealers' bid/ask spreads should vary directly with their costs of adjusting to inventory imbalances. Thus, well-diversified dealers are expected to quote lower bid/ask spreads on stocks with substantial total risk caused by undiversifiable risk. Furthermore, the effect of systematic risk on bid/ask spreads should be negligible if dealers are compensated for systematic risk by market returns. This article shows that, empirically, bid/ask spreads of OTC stocks are insensitive to the systematic risk of individual stocks—even when only stocks with stable betas are considered. Furthermore, bid/ask spreads are not sensitive to changes in market variance, as would be expected if systematic risk affected spreads. While unsystematic risk affects bid/ask spreads, its effect is pronounced for stocks traded by small, undiversified dealers. If stocks are only traded by large dealers with low diversification costs, unsystematic risk does not affect bid/ask spreads.     

PRICE AND QUANTITY QUOTES ON NASDAQ: A STUDY OF DEALER QUOTATION BEHAVIOR

We show that the majority of quotes posted by NASDAQ dealers are noncompetitive and only 19.5% (18.4%) of bid (ask) quotes are at the inside. The percentage of dealer quotes that are at the inside is higher for stocks with wider spreads, fewer market makers, and more frequent trading, and lower for stocks with larger trade sizes and higher return volatility. These results support our conjecture that dealers have greater incentives to be at the inside for stocks with larger market‐making revenues and smaller costs. Dealers post large depths when their quotes are at the inside and frequently quote the minimum required depth when they are not at the inside. The latter quotation behavior leads to the negative intertemporal correlation between dealer spread and depth.     

Determinants of Trading Profits: The Liquidity Provision Decision

Theories show that liquidity provision implies negative contemporaneous correlation between trades and returns. Dealers on the Taiwan Stock Exchange are granted typical dealer trading advantages without obligations to provide liquidity and, thus, are ideal to test whether these advantages lead to voluntary liquidity provision (earning bid-ask spreads) or information trading (trading in the direction of the market). We find a strong positive correlation in aggregate, implying that these unrestricted dealers prefer information trading. We also find that smaller dealers are more likely to provide liquidity and that small-cap stocks (with larger bid-ask spreads) are more profitable for liquidity provision.     

ANALYST REPUTATION,DEALER AFFILIATION,AND MARKET MAKING

We investigate the effects of analysts' affiliation and reputation on dealers' market making activities. We find that for a given stock, dealers who have affiliated analysts covering the stock quote and trade more aggressively than those who do not have any affiliated analysts. More important, the reputation of affiliated analysts plays an additional role in the affiliated dealer's quote and trade behavior. Dealers with affiliated star analysts post more aggressive quotes and have larger market shares than dealers with affiliated nonstar analysts. Although dealers who post more aggressive quotes also induce affiliated star analysts to cover the stocks, the positive effect of analyst reputation on the affiliated dealers' quote aggressiveness remains significant and robust after controlling for potential endogenous and simultaneous problems.     

Intra‐Dealer Integration

This paper examines the quotation behaviour of dealers who made markets in the same stocks on both NASDAQ and either EASDAQ or the LSE. Whereas previous studies examine international integration at the market level, we examine integration at the dealer level. In other words, do dealers within the same market‐making firm use information from their arm on the opposite side of the Atlantic in forming their own quotes? We find that while there is some evidence of integration at the market level, integration is hard to detect at the dealer level. The results are largely unaffected by differences in fungibility between our two samples.     

The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks

This paper provides an analysis of the nature and evolution of a dealer market for Nasdaq stocks. Despite size differences in sample stocks, there is a surprising consistency to their trading. One dealer tends to dominate trading in a stock. Markets are concentrated and spreads are increasing in the volume and market share of the dominant dealer. Entry and exit are ubiquitous. Exiting dealers are those with very low profits and trading volume. Entering market makers fail to capture a meaningful share of trading or profits. Thus, free entry does little to improve the competitive nature of the market as entering dealers have little impact. We find, however, that for small stocks, the Nasdaq dealer market is being more competitive than the specialist market.     

Market Making with Costly Monitoring: An Analysis of the SOES Controversy

This article presents a model of information monitoring andmarket making in a dealership market. We model how intensivelydealers monitor public information to avoid being picked offby professional day traders when monitoring is costly. Pricecompetition among dealers is hampered by their incentives toshare monitoring costs. The risk of being picked off by theday traders makes dealers more competitive. The interactionbetween these effects determines whether a firm quote rule improvestrading costs and price discovery. Our empirical results supportthe prediction that professional day traders prefer stocks withsmall spreads, but offer less support for the prediction thattheir trading leads to wider spreads.     

The dynamics of dealer markets and trading costs

In this study we examine the temporal dynamics of dealer market share and their ramification for competition and trading costs using a large sample of NASDAQ securities. Our results show that although the total market share of the top five dealers is relatively stable over time, there is significant monthly variation in the composition of the top five dealers. We show that market share turbulence among top dealers is another form of competition that narrows bid–ask spreads, especially for stocks with less competitive market structure.     

Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?

The NASDAQ multiple dealer market is designed to produce narrow bid-ask spreads through the competition for order flow among individual dealers. However, we find that odd-eighth quotes are virtually nonexistent for 70 of 100 actively traded NASDAQ securities, including Apple Computer and Lotus Development. The lack of odd-eighth quotes cannot be explained by the negotiation hypothesis of Harris (1991) , trading activity, or other variables thought to impact spreads. This result implies that the inside spread for a large number of NASDAQ stocks is at least $0.25 and raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.     

Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?

On May 26 and 27, 1994 several national newspapers reported the findings of Christie and Schultz (1994) who cannot reject the hypothesis that market makers of active NASDAQ stocks implicitly colluded to maintain spreads of at least $0.25 by avoiding odd-eighth quotes. On May 27, dealers in Amgen, Cisco Systems, and Microsoft sharply increased their use of odd-eighth quotes, and mean inside and effective spreads fell nearly 50 percent. This pattern was repeated for Apple Computer the following trading day. Using individual dealer quotes for Apple and Microsoft, we find that virtually all dealers moved in unison to adopt odd-eighth quotes.     

Making a Market with Spreads and Depths

Abstract:   In this paper we study the quote revision behavior of NASDAQ market makers by analyzing inter‐temporal changes in their spread and depth quotes. Using individual dealer quote and trade data for a sample of 2,319 stocks, we find that NASDAQ dealers make more frequent revisions in depths than in spreads and the extent of liquidity management is greater for stocks of smaller companies, lower‐priced stocks, and stocks with larger trade sizes and fewer number of transactions. We show that intraday variation in the number of quote revisions follows the U‐shaped pattern, indicating that the extent of liquidity management is greater during the early and late hours of trading than during midday.     

The Market Quality of Dealer versus Hybrid Markets: The Case of Moderately Liquid Securities

Abstract:  Over the last decade, electronic limit-order trading systems have been sweeping securities exchanges around the world. This paper studies a transitional case, namely, the commencement of trading of a group of moderately liquid stocks on SETS of the London Stock Exchange. The evidence reveals that the liquidity of those stocks dropped substantially after the introduction of the limit order book and the removal of the market makers' obligations. This transition provides an example that a hybrid market with a limit order book and voluntary dealers may not perform as well as a dealership market with obligatory market makers.     

The Dynamics of Dealer Markets Under Competition

The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined.     

Determinants of bid-asked spreads in the over-the-counter market

Security market regulators, among others, are concerned to know whether or not dealers are natural monopolists. Based on a randomly drawn sample of 314 over-the-counter stocks, the results of this study suggest that while there are economies of scale, they are not on the dealer level. In addition, both systematic and unsystematic risk were tested for association with the transaction costs in this market. The evidence suggests unsystematic risk is related to spread.     

Local market makers, liquidity and market quality

We examine the role of geographically proximate (local) market makers in providing liquidity and improving the quality of a dealer market. Firms with active participation of local dealers enjoy lower quoted and effective spreads, as well as more informative prices. The beneficial effects from local market makers are not confined to a few “top” local dealers and they cannot be attributed to their participation in the firm's IPO syndicate or industry specialization. Further, we find that days with aggressive bidding from local market makers relative to their non-local counterparts are associated with significant positive abnormal returns, consistent with local market makers possessing information advantages. In summary, our results suggest that the information advantages of local market makers may be a contributing factor to the reduction in the cost of trading.     

High‐Frequency Trading and the New Stock Market: Sense And Nonsense

The stock market has been transformed during the last 25 years. Human suppliers of liquidity like the NASDAQ dealers and NYSE specialists have been replaced by algorithmic market making; stocks that once traded on a single venue now trade across twelve exchanges and a multitude of alternative trading systems. New venues like dark pools, and new participants like high‐frequency traders, have emerged to take on prominent roles. This new market has had more than its share of controversy and regulatory scrutiny, particularly in the wake of Michael Lewis’s bestseller Flash Boys. In this article, the authors analyze five of the most controversial new market practices, including various high‐frequency trading strategies and dark pool activities. They set out a simple conceptual framework based on adverse selection and agency problems, and apply that framework to assess the welfare effects of each of the five practices. While much that is criticized is indeed objectionable, other controversial practices are much more complex than popularly imagined and may in fact be socially desirable. They conclude by evaluating a range of potential reforms to equity market structure.     

Competition on the Nasdaq and the growth of electronic communication networks

This paper examines the growth of electronic communication networks (ECNs) and their competitive impact on the Nasdaq. We find that the development of these alternative trading platforms is associated with tighter quoted, effective, and relative bid–ask spreads, greater depths, and less concentrated markets. Further, our results show that an increase in ECN trading may have caused some traditional market makers (wholesaler and national retail dealers) to exit the market for market making. Overall, our results suggest that ECNs provide a source of competition to traditional Nasdaq dealers.     

AN EXAMINATION OF ASKED-BID SPREADS FOR TWO OVER-THE-COUNTER MARKET SEGMENTS

Previous studies of over-the-counter (OTC) asked-bid spread behavior treat the sample stocks as a homogeneous group. Actually, there are several segments of the OTC market, ranging from the recently created National Market System to the pink sheets. We find that although previously proposed independent variables (risk, transaction rate, number of dealers, and price) determine inside spreads for two OTC market segments in ways consistent with the results of others, the models do explain the observed spreads differently.     

Is Off–Board Trading Detrimental to Market Liquidity?

Dual trading can have opposite effects: although competition between markets should induce dealers to offer cheaper transactions, market fragmentation could reduce market activity, liquidity, and exchange efficiency. This paper shows that for French stocks traded on the London Stock Exchange's SEAQ International (SEAQ–I), market activity decreases significantly in the Paris Bourse during UK bank holidays. Thus, SEAQ–I market makers seem to divert a new clientele to the Paris Bourse, increasing both market activity and the breadth of the Bourse's order book. Also, contrary to the fragmentation hypothesis, dual trading does not seem to increase information asymmetry.     

DAY‐END EFFECT ON THE PARIS BOURSE

We study the day‐end effect on the Paris Bourse, a computerized order‐driven market with competing dealers. The day‐end return is approximately double the magnitude found in U.S. data and is nearly four times larger for stocks trading with a registered dealer. However, this is largely explained by the time between trades and the bid‐ask spread. Unlike the U.S. data, the effect does not decline as stock price increases, probably because of a variable tick size in the Paris market. Finally, a change to a closing call auction in May 1996 for a subset of stocks did not reduce the day‐end effect.