| Abstract: | 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. |
