The Quotation Behavior of ECNs and Nasdaq Market Makers

Abstract

We examine the impact of three Nasdaq rule changes on some aspects of quality. In particular we investigate the quotation behavior of makers following the reduction in tick size from eighths to sixteenths on June 2, 1997; the direct impact of including electronic communication network (ECN) quotes in the calculation of Nasdaq quotes; and the efficacy of the Actual Size Rule (ASR) during a time of stress. We find that following the tick size reduction Nasdaq makers again appear to be avoiding odd ticks (now odd sixteenths), but traders entering orders on ECNs appear to be more likely to use all ticks. We also find that ECNs establish the inside market and hence reduce trading costs for the public about 19% of the time. Finally, our findings suggest that the ASR led to a significant reduction in bid liquidity during the sharp downturn of October 27-28, 1997. From a regulatory perspective, the results of our study suggest that while some of the reforms have improved quality, there are still major impediments to quote price competition and certain changes may have reduced liquidity. The nature of the data used in this study allows us to test three competing hypotheses for odd tick avoidance: natural behavior; preferencing of order flow; and conspiracy among oligopolistic makers. We find no support for the natural clustering hypothesis and some inconsistencies with the preferencing hypothesis. Our findings are generally consistent with the tacit collusion hypothesis.