Academic journal article Quarterly Journal of Business and Economics

The Impact of Limit Order Handling on the NYSE and NASDAQ Transaction Costs (+)

Academic journal article Quarterly Journal of Business and Economics

The Impact of Limit Order Handling on the NYSE and NASDAQ Transaction Costs (+)

Article excerpt


Optimal security market design is an important issue for both academics and practitioners. The questions "What constitutes an optimal market design?" and "Which of the existing stock markets is more efficient?" long have been important topics. The desirable characteristics of an ideal market design should include an efficient price discovery process without excessive costs of trade execution and price volatility. There has been great interest in comparing the trading costs between the New York Stock Exchange (NYSE) and Nasdaq markets, and debates have arisen over the size of spreads on Nasdaq. Before Nasdaq adopted the Security Exchange Commission's (SEC) mandated order handling rule (OHR), (1) most studies find that average trading costs on the Nasdaq stock market are larger than those on the NYSE stock market. (2) The debate is why the trading costs are higher on Nasdaq than on the NYSE. (3)

Much of the interest in this issue is spurred by Christie and Schultz (1994) and Christie, Harris, and Schultz (1994). They show the pattern of quotes for actively traded large firms on the Nasdaq market and find that odd-eighth quotes are virtually nonexistent for most of these firms, even though the minimum tick on Nasdaq is one-eighth of a dollar or less. This implies a spread of at least a quarter dollar for most of Nasdaq quotes. They conclude that the market makers on Nasdaq implicitly collude to maintain wider spreads.

Barclay (1997) shows that spreads become smaller when the stocks for which Nasdaq market makers avoid odd-eighth quotes move from the Nasdaq to the NYSE or Amex stock markets. Barclay supports the conclusion that the avoidance of odd-eighth quotes is used as a coordination device among the Nasdaq market makers to increase bid-ask spreads to above-competitive levels because even-eighth quotes are rounded prices and hence the natural focal points. Bessembinder and Kaufman (1997) compare average trade execution costs during 1994 for stocks listed on the NYSE and Nasdaq markets. They conclude that the average execution costs are greater for trades on the Nasdaq-listed firms compared to matched NYSE-listed firms and the differences in trading costs cannot be attributed to economic factors, such as firm size, return volatility, share price, or trading volume, which will likely affect the trading costs.

Besides the tacit collusion hypothesis asserted by Christie and Schultz for wider spreads on Nasdaq market, numerous other explanations have been proposed. Some argue that due to structural differences between the NYSE and Nasdaq markets, the trading costs are expected to be higher and the spreads are expected to be wider on the Nasdaq market. Huang and Stoll (1996) and Godek (1996) stress the practice of internalization and preferencing of order flow as important factors that limit dealers' incentives to narrow spreads. Internalization means that Nasdaq broker-dealers have no obligation to forward orders to the dealers who post the best quotes. Instead, they can execute the orders against their own account as long as they match the best inside quotes. Preferencing occurs when the retail firms redirect or preference the orders to dealers who do not post the best current quotes but have agreed to match the best quotes when receiving the orders. Because of internalization and preferencing, the dealers with the better inside quotes do not necessarily get more order flow and the profits from their existing order flow are reduced. Thus, preferencing limits the incentives for competition among dealers.

Ho and Macris (1985) argue that Nasdaq, being a multiple dealer market, should have greater market depth and wider spreads because the collective ability of dealers to carry inventory to absorb order imbalances is higher on a multiple dealer market, while any single dealer has limited ability to adjust his or her inventory position because he or she faces competition from other dealers who may have smaller inventory positions. …

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