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.     

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.     

Price Discovery without Trading: Evidence from the Nasdaq Preopening

This paper studies Nasdaq market makers' activities during the one and one-half hour preopening period. Price discovery during the preopening is conducted via price signaling as opposed to the auction used to open the NYSE or the continuous market used during trading. In the absence of trades, Nasdaq dealers use crossed and locked inside quotes to signal to other market makers which direction the price should move. Furthermore, we find evidence of price leadership among market makers that bears little resemblance to their IPO\SEO lead underwriter participation.     

Trades outside the quotes: Reporting delay,trading option,or trade size?

In the period 1993 through 2002 examined in this study, quoted and effective spreads declined substantially on Nasdaq and to a lesser degree on the NYSE. At the same time, however, trades outside the quotes increased dramatically on Nasdaq. Because investors would prefer to trade at the quotes rather than outside the quotes, we examine why trades outside the quotes are observed. We focus on how the continuous market mechanism itself influences the outcome of orders and the reporting of trades, and we conclude that slippage exists in the market mechanism. Outside-trades occur on Nasdaq, first, because of delays in reporting trades, second, because the ability of dealers to delay execution of trades creates a look-back option, which when exercised results in outside-trades, and third, because large trades can take place at prices outside the quotes. Outside-trades are rarely observed on the NYSE because the market is more centralized. While the pattern of trading on the NYSE is not inconsistent with the presence of a look-back option, our tests provide no direct evidence that specialists are exercising such an option.     

Who makes markets

A dealer needs access to order flow and information to make a market profitably in a Nasdaq stock. Several variables that proxy for the stocks that an individual market maker's brokerage customers trade, including volume, location, underwriting participation and analyst coverage, are significant determinants of market making activity. Informational advantages may also factor in the market making decision as evidenced by dealers specializing in industries. These findings suggest that individual dealers have competitive advantages in making markets in specific stocks, and that potential market making competition comes from the dealers who share those advantages rather than all Nasdaq market makers.     

RECENT GROWTH IN NASDAQ TRADING VOLUME AND ITS RELATION TO MARKET VOLATILITY

We document a significant increase in Nasdaq trading volume relative to New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) trading volumes. Although recent increases in the number of shares traded are reported in the financial press, we also find it present in the percentage of dollar values traded. We then examine correlations between trading volume and several measures of market volatility. Nasdaq volume appears to be more closely correlated with residual variance, while NYSE and AMEX volumes are more closely correlated with overall market variance. We conclude that the type and quantity of information driving trading are different on Nasdaq than on the two exchanges, and that the relative growth in Nasdaq volume cannot be attributed solely to differences in the methods of counting volume in the two market environments.     

Competition For Order Flow, Market Quality, And Price Discovery In The Nasdaq 100 Index Tracking Stock

We investigate competition for order flow, market quality, and price discovery in the Nasdaq 100 Index Tracking Stock (QQQ). The QQQ, an AMEX‐listed, exchange‐traded fund, is the most actively traded security in the U.S. equities market. On July 31, 2001, the NYSE began trading the QQQ, marking the first time it traded securities of companies it does not list. The greatest volume of trading takes place on electronic communication networks (ECNs), following by trading on the AMEX and the NYSE. Most of the block trades are executed on the AMEX, where the bid‐ask spreads are narrower. We find that ECNs contribute the most to the price‐discovery process. The spreads on all trading platforms have decreased and market quality and price discovery have improved since QQQ shares have traded on the NYSE.     

The Post-Reform Bid-Ask Spread Disparity between Nasdaq and the NYSE

We report further evidence of the difference in execution costs between Nasdaq and the NYSE before and after the 1997 market reforms. We find that informed trading costs are consistently higher on Nasdaq both before and after the reforms. In the pre‐reform period the Nasdaq‐NYSE disparity in bid‐ask spreads cannot be completely attributed to the difference in informed trading costs. However, in the post‐reform period the spread difference between these two markets becomes insignificant with the effect of informed trading costs controlled. Our findings are consistent with the contention that the reforms have largely reduced noninformation trading costs and dealers' rents.     

Semi‐transparency,dealership market,and foreign exchange market quality

This paper examines the effects of a semi-transparency event, the introduction of the electronic trading system (EBS), on the market quality of a typical dealership market – the FX market. We find that increasing transparency leads to smaller quote disagreement among dealers and higher trading volume, but the beneficial effects are bigger for uninformed dealers than informed dealers. We also find that information efficiency improves overall in the semi-transparent system; however, informed dealers are found to quote less aggressively in the more transparent market. We conclude that semi-transparency raises market quality in general, but that it is the uninformed dealers who benefit more from this increased quality.     

Order imbalance and liquidity supply: Evidence from the bubble burst of Nasdaq stocks

In this study we analyze the effect of order imbalance on the quotation behavior of Nasdaq market makers. We find that Nasdaq market makers use both price and quantity quotes when dealing with order imbalances. However, order imbalance affects only price movement, not spreads. We also find that Nasdaq market makers quote more shares and compete more intensively on bid-side (ask-side) when public sells (buys) exceed public buys (sells). These suggest that market makers increase liquidity supply when order imbalances exist. More interestingly, we show that both market conditions and price movements affect investors' trading behavior.     

What Explains the Bid‐Ask Spread Decline after Nasdaq Reforms?

This paper examines whether the decrease in bid‐ask spreads on Nasdaq after the 1997 reforms is due to a decrease in market‐making costs and/or an increase in market competition for order flows. Unlike previous studies, we jointly examine how competition and trading costs affect bid‐ask spreads. In addition, we separate the effects of informed trading and liquidity costs on bid‐ask spreads. Informed trading cost is directly estimated for each Nasdaq stock using a Bayesian theoretic model. Empirical results show that market‐making costs and competition significantly affect bid‐ask spreads. The post‐reform decrease in bid‐ask spreads is largely due to both an increase in competition and a decrease in informed trading and liquidity costs on Nasdaq.     

Getting Out Early: An Analysis of Market Making Activity at the Recommending Analyst's Firm

This paper examines trading volume for Nasdaq market makers around analyst recommendation changes issued by an analyst at the same firm. Using Nasdaq PostData, we find a disproportionate increase in market making volume associated with the firm's recommendation changes and evidence of elevated sell volume at the recommending analyst's firm in the 2 days preceding a downgrade. The implications are that the information source matters in determining the placement of trades and that the issuing analyst's firm appears to be rewarded for prereleasing information through increased volume. These findings constitute new evidence of compensation for research production through the market making channel.     

Nasdaq Trading and Trading Costs: 1993–2002

Nasdaq spreads decline from 1993 to 2002, largely independently of tick‐size reductions. Trade size declines, consistent with greater retail investor activity. Using the method of Chordia, Roll, and Subrahmanyam (2001), we find that concurrent market returns strongly affect liquidity and trading activity. Liquidity exhibits distinct day‐of‐the‐week patterns. There is little evidence that macroeconomic announcements or changes in key interest rates affect Nasdaq stocks overall; but in the bear market, we find a relation between some of these variables and effective spreads, which we interpret as consistent with Nasdaq participants' paying greater attention to fundamentals after the market crash.     

Market Making and Trading in Nasdaq Stocks

This paper examines the relations between the number of market makers, trading activity, and price improvement in Nasdaq stocks, using a model motivated by Grossman and Miller (1988). Results indicate a positive relation between the number of market makers and trading frequency, and that competition among market makers reduces effective bid-ask spreads. Results estimated using a simultaneous equations framework support the model predictions of Grossman and Miller. Results also indicate that trading frequency may be more important than trade size in determining the number of market makers.     

Informed trading in hybrid bond markets

I study the impact of pretrade transparency on trading activity in an environment where dealers, informed and uninformed alike, can choose between an electronic limit order book (LOB) and an over-the-counter (OTC) market. By investigating bond dealers' choice in the hybrid Norwegian government bond market, I explore whether they base their trading strategy on the perceived informativeness of their trades. The results imply that bond dealers act strategically to preserve the value of their information by choosing the immediacy of the LOB when trades contain information. This suggests that OTC trades are exposed to a leakage of information to other dealers.     

Filter Tests In Nasdaq Stocks

This study examines the performance of filter and dual moving-average crossover trading rules applied to Nasdaq stocks. We find that trading rules conditioned on a stock's past price history perform poorly, but those based on past movements in the overall Nasdaq Index tend to earn statistically significant abnormal returns. Since there is a high level of transaction costs in this market, these abnormal returns are generally not economically significant. However, there are indications that pursuing some of these strategies can be worthwhile in carefully selected subsets of stocks.     

Evidence and Implications of Increases in Trading Volume Around Exchange Listings

After controlling for market volume trends and differences in volume measurement between the Nasdaq and the exchanges, we find that mean trading volumes increase significantly for Nasdaq stocks that list on the Amex or the NYSE. Furthermore, stocks with low (high) pre‐listing volume tend to realize the largest volume increases (decreases) as well as the best (worst) post‐listing performance. Our results support the hypothesis that stocks with high past trading volumes tend to experience lower future returns, and shed new light on the nature and possible causes of poor post‐listing stock performance.     

Herding and the information content of trades in the Australian dollar market

This study shows that the information content of FX transactions depends on the identity of market participants. Using spot FX transactions of a major Australian bank, we find that central banks have the greatest price impact, followed by non-bank financial institutions (NBFIs) such as hedge funds and mutual funds. Trades by non-financial corporations have the least impact on dealer pricing. In the interbank market, dealers with greater private information tend to choose direct trading which has lower post-trade transparency. Indirect trading via brokers is partially revealed to the market and has little price impact. The price impact largely comes from institutions in the top quartile of the trading volume. Furthermore, NBFIs have the greatest propensity for herding, followed by interbank dealers. Non-financial corporations do not herd in their trades. Except for central banks, the differential impact of market participants can largely be explained by their propensity for herding.     

The Quality of ECN and Nasdaq Market Maker Quotes

This paper compares the quality of quotes submitted by electronic communication networks (ECNs) and by traditional market makers to the Nasdaq quote montage. An analysis of the most active Nasdaq stocks shows that ECNs not only post informative quotes, but also, compared to market makers, ECNs post quotes rapidly and are more often at the inside. Additionally, ECN quoted spreads are smaller than dealer quoted spreads. The evidence suggests that the proliferation of alternative trading venues, such as ECNs, may promote quote quality rather than fragmenting markets. Moreover, the results suggest that a more open book contributes to quote quality.     

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.