Competitiveness and Price Setting in Dealer Markets

4 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Third Quarter 1998 Bid and ask quotes are prices at which dealers or market makers are willing to transact. A market maker is an individual or firm that risks its own capital to provide investors with immediacy of supply and demand. The bidask spread represents the cost to investors of transacting with the market maker. Investors prefer a narrow spread because it reduces trading costs and improves liquidity (Amihud and Mendelson 1986). Bid-ask spreads, like other transaction costs, significantly affect the efficiency of capital markets (Bhushan 1994; Kim and Verrechia 1994). In an efficient market, prices quickly reflect new information so that the information cannot be used to derive abnormal trading profit. Stock markets are thought to be more efficient when spreads are narrow because information is disseminated more quickly. Yet, at the same time, dealers must receive adequate compensation for making a market in a security, or the market’s liquidity is threatened. Regulators and investors have asserted that Nasdaq dealers conspire to widen bid-ask spreads in order to in-crease their profit at investors’ expense. Academics have amassed a substantial body of evidence relating to the Nasdaq scandal. Yet there is no consensus concerning whether dealers collude to fix prices and widen bid-ask spreads.1 Observed spreads may result from institutional features particular to the Nasdaq market rather than collusion among market makers. This article explores the Nasdaq pricing controversy in light of economic theory and evidence of alleged collusion, including evidence contained in U.S. Department of Justice and Securities and Exchange Commission reports (1996). The following section examines the important role that securities markets play in promoting a stable economy. Then the discussion reviews specifics of the two organizational structures commonly adopted—auction and dealer markets. These initial sections provide a foundation for understanding the significance of the Nasdaq controversy. Subsequently the article considers the sources and economic consequences of divergence in spreads. Finally, it elaborates on what constitutes collusive behavior and summarizes the case against Nasdaq.