Intraday Variation in the Bid-Ask Spread: Evidence after the Market Reform

In this article we show that intraday variation in spreads for Nasdaq‐listed stocks has converged to intraday variation in spreads for NYSE‐listed stocks after the implementation of the new order‐handling rules. We attribute this convergence to the Limit Order Display Rule, which requires that limit orders be displayed in Nasdaq best bid and offer when they are better than quotes posted by market makers. Our findings suggest that the different patterns of intraday spreads between NYSE and Nasdaq stocks reported in prior studies can largely be attributed to the different treatment of limit orders between the NYSE and Nasdaq before the market reform.     

Liquidity Measurement Problems in Fast,Competitive Markets: Expensive and Cheap Solutions

Do fast, competitive markets yield liquidity measurement problems when using the popular Monthly Trade and Quote (MTAQ) database? Yes. MTAQ yields distorted measures of spreads, trade location, and price impact compared with the expensive Daily Trade and Quote (DTAQ) database. These problems are driven by (1) withdrawn quotes, (2) second (versus millisecond) time stamps, and (3) other causes, including canceled quotes. The expensive solution, using DTAQ, is first‐best. For financially constrained researchers, the cheap solution—using MTAQ with our new Interpolated Time technique, adjusting for withdrawn quotes, and deleting economically nonsensical states—is second‐best. These solutions change research inferences.     

Trades and Quotes: A Bivariate Point Process

This article formulates a bivariate point process to jointlyanalyze trade and quote arrivals. In microstructure models,trades may reveal private information that is then incorporatedinto new price quotes. This article examines the speed of thisinformation flow and the circumstances that govern it. A jointlikelihood function for trade and quote arrivals is specifiedin a way that recognizes that an intervening trade sometimescensors the time between a trade and the subsequent quote. Modelsof trades and quotes are estimated for eight stocks using Tradeand Quote database (TAQ) data. The essential finding for thearrival of price quotes is that information flow variables,such as high trade arrival rates, large volume per trade, andwide bid–ask spreads, all predict more rapid price revisions.This means prices respond more quickly to trades when informationis flowing so that the price impacts of trades and ultimatelythe volatility of prices are high in such circumstances.     

The Impact of the Reduction in Tick Increments in Major U.S. Markets on Spreads,Depth, and Volatility

This study presents an analysis of the impact of the introduction of quotes in sixteenths of a dollar on the AMEX, Nasdaq, and NYSE in mid-1997 on select market characteristics such as spreads, effective spreads, quoted depth, and volume. The findings of the study document reductions in the bid-ask spread, effective spread, and a statistically significant increase in the number of quotes. Interestingly, we find that liquidity, as measured by the total depth at the bid and ask, declines significantly on the AMEX and NYSE, but increases on the Nasdaq. Trading volume increases on the NYSE, but remains unchanged for the AMEX and Nasdaq. We also find that the proportion of even-increment quotes is a relevant factor affecting percentage spreads for Nasdaq both before and after and for the NYSE only after the change in quoting increments.     

Estimating the Probability of Informed Trading

Using a new empirical model, I estimate the probability of trades being generated by privately informed traders. Inference is drawn on a trade‐by‐trade basis using data samples from the New York Stock Exchange (NYSE). The modeling setup facilitates in‐depth analysis of the estimated probability of informed trading at the intraday level and for stocks with different levels of trading activity. The most important empirical results are: (a) the intradaily pattern of the inferred probability of informed trading is highly correlated with the intradaily pattern of observed quoted spreads, (b) differences in the magnitude of quoted spreads across volume categories are not exclusively related to differences in the level of informed trading, and (c) private information is incorporated faster in the quotes for high‐volume stocks than in the quotes for low‐volume stocks.     

THE DYNAMICS OF QUOTED LIQUIDITY AROUND LARGE TRADES ON THE NYSE

Large trades have potentially disruptive effects on the continuation of subsequent trade. If the large trade executes against volume from limit orders or specialist quotations, continued trade may be unavailable until new liquidity enters the market. Evidence presented in this paper indicates that large trades on the NYSE are followed by decreases in quoted liquidity, which last for an average of fifteen minutes. Both the decreases in quoted liquidity and the time to its subsequent return are related to trade-specific factors. This evidence suggests that not all large trades have the same effect on the continuation of trade.     

TRADE SIZE AND INFORMED TRADING: WHICH TRADES ARE “BIG”?

We find adverse‐selection spread components increase sharply in the ratio of trade size to quoted depth, and spike when trade size equals quoted depth. We find that two previously documented and prominent indicators of informed trading, raw trade size and high‐trading volume half‐hours, offer almost no explanatory power for informed trading measures beyond trade size to quoted depth, and a third indicator, time of day, offers no explanatory power among trades with high trade size to quoted depth. Our results suggest trade size to quoted depth is perhaps the single most important indicator that a trade is informed.     

Post-Reform Market-Order Execution Quality: Multidimensional Comparisons Across Market Centers

We use market‐order data to determine execution quality on the NYSE, four regional stock exchanges, and the Nasdaq InterMarket. We examine a sample period after the reduction in the minimum price variation and after the SEC imposed new order‐handling rules, and analyze dimensions of execution quality in addition to trade prices. We find that in the postreform environment, the NYSE offers execution prices that are more favorable to the investor. However, the regional exchanges and the InterMarket offer executions that are faster and that more frequently allow investors to execute orders with sizes exceeding the quoted depth at the quoted price.     

THE DEALERS' PRICE/SIZE QUOTE AND MARKET LIQUIDITY

We model trading in a competitive securities market where informed traders and liquidity traders transact with dealers. The dealers' entire published quote is modeled: bid-ask prices and the number of shares the dealer is willing to buy/sell at these prices (i.e., size quotes). We argue that size quotes are a more informative indicator of market liquidity than the bid-ask spread's adverse-selection component. Moreover, the size quotes reveal several market characteristics that cannot be inferred from the bid-ask spread's adverse-selection component alone. The model generates a number of empirically testable predictions that clarify certain key elements of market liquidity.     

Trade classification algorithms for electronic communications network trades

Ellis et al. [Ellis, K., Michaely, R., O’Hara, M., 2000. The accuracy of trade classification rules: Evidence from Nasdaq. Journal of Financial and Quantitative Analysis 35 (4), 529–551] find that trade classification rules have limited success in classifying trades which execute inside the quotes. We reconfirm this result and propose an alternative algorithm to improve the classification accuracy for trades inside the quotes. This alternative algorithm improves the overall success rate for classifying trades, especially for trades that occur inside the quotes. Additionally, we show that the Lee and Ready [Lee, C., Ready, M., 1991. Inferring trade direction from intraday data. Journal of Finance 46, 733–747] and Ellis et al. (2000) trade classification algorithms provide biased estimates of the actual effective spreads and price impacts, while our algorithm provides statistically unbiased estimates of actual effective spreads and price impacts.     

A Specialist's Quoted Depth and the Limit Order Book

By partitioning quoted depth into the specialist's contribution and the limit order book's contribution, the paper investigates whether specialists manage quoted depth to reduce adverse selection risk. The results show that both specialists and limit order traders reduce depth around information events, thereby reducing their exposure to adverse selection costs. Moreover, specialists' quotes may reflect only the limit order book on the side (or sides) of the market where they believe there is a chance of informed trading. Changes in quoted depth are consistent with specialists managing their inventory as well as having knowledge of the stock's future value.     

Trading and Liquidity on the Tokyo Stock Exchange: A Bird's Eye View

The trading mechanism for equities on the Tokyo Stock Exchange (TSE) stands in sharp contrast to the primary mechanisms used to trade stocks in the United States. In the United States, exchange-designated specialists have affirmative obligations to provide continuous liquidity to the market. Specialists offer simultaneous and tight quotes to both buy and sell and supply sufficient liquidity to limit the magnitude of price changes between consecutive transactions. In contradistinction, the TSE has no exchange-designated liquidity suppliers. Instead, liquidity is provided through a public limit order book, and liquidity is organized through restrictions on maximum price changes between trades that serve to slow down trading. In this article, we examine the efficacy of the TSE's trading mechanisms at providing liquidity. Our analysis is based on a complete record of transactions and best-bid and best-offer quotes for most stocks in the First Section of the TSE over a period of 26 months. We study the size of the bid-ask spread and its cross-sectional and intertemporal stability; intertemporal patterns in returns, volatility, volume, trade size, and the frequency of trades; and market depth based on the response of quotes to trades and the frequency of trading halts and warning quotes.     

Market changes and spread components,implications for international markets

Trading in international markets is changing and evolving due to competitive pressure and technological innovations. Evidence of changes are seen on the London Stock Exchange, Amsterdam Stock Exchange, the Swiss Exchange, and the Deutsche Borse. This paper examines changes in the components of Nasdaq spreads following the implementation of new Order Handling Rules in early 1997 and the reduction in minimum tick size from $0.125 to $0.0625 in June 1997. Trading volume increases and spreads decrease significantly following each change. We find that order processing and asymmetric information costs decline following each rule change. Inventory holding costs increase over the sample period. Also, we find a significant increase in the probability of a trade flow reversal after the implementation of the Order Handling Rules.     

Index futures arbitrage before and after the introduction of sixteenths on the NYSE

We find that market efficiency increased and the arbitrage link between index futures and the stock market strengthened after June 24, 1997, when the New York Stock Exchange reduced the minimum change for stock prices and quotes from an eighth to a sixteenth of a dollar. There has been a substantial increase in the number of arbitrage trades reported to the Securities and Exchange Commission (SEC) since the reduction in the minimum price increment. The average number of stocks traded and the average dollar amount underlying each arbitrage trade increases and decreases, respectively. The average index futures mispricing error (MPE) that triggers arbitrage is lower and reverts to zero more quickly.     

Changing the rules again: Short selling in connection with public equity offers

We study the impact of two recent regulations that impose restrictions on short selling. First, since October 2007 any investor that short sells a firm’s stock is prohibited from purchasing shares in the firm’s seasoned equity offering (SEO) if the short occurred in the five days prior to the offering (pursuant to an amendment to Rule 105). Previously Rule 105 only disallowed investors from covering a pre-issue short sale with shares purchased in the offering. We hypothesize that the amended rule has the unintended consequence of greater discounting for overnight offers, which are not announced in advance, because the rule excludes some potential buyers and thereby forces underwriters to set lower offer prices to fully distribute the offer. The evidence supports this hypothesis. Second, we examine the impact of the SEC’s 2008 Emergency Order that greatly curtails naked short selling on all stocks under its jurisdiction. We find that the Emergency Order is associated with large increases in discounting for offers announced in advance, suggesting that the removal of naked short sellers is associated with reduced pre-SEO pricing efficiency. Taken together, the results imply that recent restrictions on short selling have significant unintended effects on the capital raising process.     

Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks

The relative merits of dealer versus auction markets have been a subject of significant and sometimes contentious debate. On January 20, 1997, the Securities and Exchange Commission began implementing reforms that would permit the public to compete directly with Nasdaq dealers by submitting binding limit orders. Additionally, superior quotes placed by Nasdaq dealers in private trading venues began to be displayed in the Nasdaq market. We measure the impact of these new rules on various measures of performance, including trading costs and depths. Our results indicate that quoted and effective spreads fell dramatically without adversely affecting market quality.     

Do political connection disruptions increase labor costs in a government-dominated market? Evidence from publicly listed companies in China

This paper investigates whether the disruption of political connections increases labor costs among Chinese listed firms. Using the Communist Party of China's Rule No. 18 as an exogenous shock that forces firms to lose their politically connected independent directors, we find that the disruption of political connections is associated with an increase in labor costs (both in terms of aggregate labor costs per firm and average labor costs per employee) and an increase in employee turnover. Such increases do not lead to labor productivity improvements, and cannot be attributed to changes in corporate policies or the composition of labor forces after Rule No. 18. We also find that firms with higher unemployment risk and skilled labor risk increase their labor costs to a larger extent. Our results are robust to alternative labor cost measures, controlling for potential confounding events, and alternative political connection channels. Our study shows an unintended labor market consequence—increases in labor costs—of political connection disruptions for firms that are adversely affected by such disruptions.     

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.     

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.