Why Effective Spreads on Nasdaq were Higher than on the New York Stock Exchange in the 1990s

Abstract

Two hypotheses have been advanced to explain why spreads on Nasdaq were substantially higher than those on the NYSE in the 1990s - collusion and preferencing and payment for order flow. We present data on all actively traded stocks of relative effective spreads (RES) on these markets, aggregated monthly over 1987-1999 and advance a third hypothesis: Nasdaq SOES-day-trading. We estimate Nasdaq and NYSE informed-trade losses and gains to market makers on six trade sizes, and find that losses on trades we ascribe to SOES day traders were substantially greater than those on other trades, offset somewhat by gains to small-trade-size investors. Nasdaq market makers' response resulted in greater RES and increased trading within the best quotes, predominantly on larger trade sizes. Among market makers' customers, the costs of SOES day trading were borne largely by traders of the smaller trade sizes. The data are consistent with the SOES-day-trading hypotheses, but not with the other two. Furthermore, the mandatory SOES experiment gave impetus to trading via ECNs, which now dominate Nasdaq.