نظم عملکردی و کیفیت بازار در NASDAQ قبل و بعد از اعشاری شدن

Despite the widely held belief that order preferencing affects market quality, no hard evidence exists on the extent and determinants of order preferencing and its impact on dealer competition and execution quality. This study shows that the bid-ask spread (dealer quote aggressiveness) is positively (negatively) related to the proportion of internalized volume during both the pre- and post-decimalization periods. Although decimal pricing led to lower order preferencing on NASDAQ, the extent of order preferencing after decimalization is higher than what prior studies had predicted. The price impact of preferenced trades is smaller than that of unpreferenced trades and preferenced trades receive greater (smaller) size (price) improvements than unpreferenced trades.

Brokers and dealers on NASDAQ routinely direct or preference customer orders to any dealer who agrees to honor the best quoted price regardless of the price quoted by the dealer to whom the order is directed. In return for the routing of orders, dealers commonly offer either direct monetary payments or in-kind goods and services to brokers. Brokers and dealers also frequently internalize their order flow on NASDAQ. Internalization, a subset of preferencing, is the direction of order flow by a broker-dealer to an affiliated dealer or order flow executed by that broker-dealer as market maker. Although prior studies offer both analytical predictions and experimental evidence regarding the effects of order preferencing on execution costs,1 extant studies offer limited evidence on the extent and determinants of preferencing and its impact on market quality. In the present study, we address the following questions using a large sample of NASDAQ-traded stocks: (1) How extensive is preferencing on NASDAQ? Which stocks, which dealers, and which trades are more likely to be involved in preferencing? (2) How does decimal pricing affect preferencing? (3) How does preferencing affect spreads and dealer quote aggressiveness? (4) Does preferencing allow dealers to separate informed traders from uninformed traders? and (5) Do preferenced orders receive better price and size improvements? Several studies analyze order preferencing for exchange-listed stocks. Hansch et al. (1999) investigate the effect of preferencing and internalization on spreads and dealer profits for a sample of London Stock Exchange (LSE) stocks. The authors find that while preferenced trades pay higher spreads, they do not generate higher dealer profits. In contrast, they find that internalized trades pay lower spreads. However, the study finds no evidence of significant relations between the spread and preferencing or internalization across stocks. Although the LSE, like NASDAQ, is largely a dealer market, the results found on the LSE may not hold on NASDAQ because dealer competition for order flow on the LSE is different from that on NASDAQ. On NASDAQ, there are more than 400 market makers competing for order flow. In contrast, there are only 21 market makers on the LSE and the majority of them compete for business primarily in the large (FTSE-100) stocks. Furthermore, it is illegal on the LSE to make cash payments to purchase the order flow, whereas such payments are allowed on NASDAQ. Chordia and Subrahmanyam (1995) suggest that brokers channel customer orders to non-NYSE market makers for order flow payments even if they are aware that NYSE orders execute at better than quoted prices. They find that trades executed on the NYSE have, on average, a higher price improvement rate than trades executed off the NYSE. Battalio et al. (1997) show that internalization of order flow on regional exchanges has little short-run effect on posted or effective bid-ask spreads at the national level. The authors attribute this result to the degree of market fragmentation being too small. Because the extent of market fragmentation and dealer competition for NASDAQ-traded stocks is greater than that for exchanged-listed stocks, preferencing may exert a stronger impact on NASDAQ. Peterson and Sirri (2003) conclude that preferencing in exchange-listed stocks has not damaged market quality. The Securities and Exchange Commission (1997) also examined the issue of preferencing in detail in a 1997 report. The Commission concludes that while order preferencing reduces order interaction, it does not inhibit dealers from providing executions of customer orders at the best prices. Battalio 2001a and Battalio 2001b examine order preferencing on NASDAQ using proprietary data from Knight Securities. Battalio et al. (2001a) find that the dealer's gross market-making revenue varies substantially across brokers. The study concludes that payment for order flow can survive decimalization if dealers customize payment schedules by paying some brokers more than others based on the information content of order flow. Battalio et al. (2001b) examine the division of market-making revenue among dealer, broker, and trader. They find that the net trading cost of the broker refusing order-flow payments does not dominate the net trading cost of all brokers selling order flow to Knight. The study concludes that payment for order flow does not unambiguously harm traders and casts doubt on the conclusions of extant studies using only trade prices to assess market quality. Although prior studies provide valuable insight into the impact of order preferencing on dealer competition and execution quality, there are still many unanswered questions. In this paper, we provide further evidence on the extent and effect of order preferencing on NASDAQ using data before and after decimalization. Unlike previous studies that utilize data from one market maker, we use quote and trade data for a large number of NASDAQ dealers. While prior research focuses mostly on order preferencing on regional exchanges and the nature of competition between NYSE and non-NYSE market makers, our focus is order preferencing on NASDAQ and competition among NASDAQ dealers. Because the nature and extent of competition among NASDAQ dealers are different from those between NYSE and non-NYSE market makers, our study sheds further light on the effect of order preferencing on market quality. In addition, our study provides evidence regarding the impact of decimalization on order preferencing. Prior studies offer conflicting predictions regarding the effect of decimal pricing on order preferencing. Chordia and Subrahmanyam (1995), Kandel and Marx (1999), and Harris (1999) predict that decimal pricing could greatly reduce order preferencing. In contrast, Benveniste et al. (1992), Battalio and Holden (2001), and Battalio et al. (2001a) predict that decimalization has only a marginal effect on preferencing. We shed light on this debate by comparing the extent of preferencing immediately before and after decimalization. We also compare price impact and price/size improvements between preferenced and unpreferenced trades and thereby determine whether preferenced trades have smaller information contents and receive better executions as some researchers suggested. Our empirical results show that order preferencing is prevalent on NASDAQ during both the pre- and post-decimalization periods. Although the implementation of decimal pricing lowered the extent of order preferencing, the proportion of preferenced trades after decimalization is much higher than what prior studies (e.g., Chordia and Subrahmanyam, 1995; Kandel and Marx, 1999; Harris, 1999) have suggested. We find a significant and positive (negative) relation between spreads (dealer quote aggressiveness) and the extent of internalization during both periods. The price impact of preferenced trades is significantly smaller than the price impact of unpreferenced trades, and preferenced trades receive greater (smaller) size (price) improvements than unpreferenced trades. The paper is organized as follows. Section 2 describes data sources and sample selection procedures and presents descriptive statistics. Section 3 discusses the extent and determinants of order preferencing and presents evidence on how decimal pricing affects order preferencing and execution costs. Section 4 analyzes the effects of internalization on spreads and dealer quote aggressiveness. Section 5 compares price impact, price improvement, and size improvement between preferenced and unpreferenced trades. Section 6 provides a brief summary and concluding remarks.

Despite the widely held notion that order preferencing has detrimental effects on market quality and may have led to wider bid-ask spreads on NASDAQ, there has been no prior direct evidence on the cross-sectional relation between NASDAQ execution costs and the extent of order preferencing. In the present study, we provide new evidence on these issues using a large sample of NASDAQ stocks before and after decimalization.Our empirical results suggest that order preferencing is prevalent on NASDAQ during both the pre- and post-decimalization periods. Although decimal pricing results in lower preferencing, the post-decimal proportion of preferenced volume is still much higher than what some people had predicted. Dealer quote aggressiveness (the spread) is significantly and negatively (positively) related to the extent of internalization during both the pre- and post-decimalization periods. Consistent with the prediction of the clientele-pricing hypothesis advanced in several recent studies, we find that the price impact of preferenced trades is smaller than that of unpreferenced trades. Market makers help affiliated brokers and brokers with preferencing agreements by offering greater size improvements. Although the present study provides some new evidence regarding the effects of order preferencing on dealer quote competition and execution costs, the net effect of order preferencing on investor welfare is not obvious because order preferencing is likely to have broad and diverse ramifications for investor welfare. For example, order preferencing can reduce broker search costs, allowing the savings to be passed along to customers in the form of reduced commissions. In addition, there are dimensions of market quality other than price competition, such as speed of execution and reliability. Preferencing can also improve these areas of market quality. The accurate quantification of these benefits is likely difficult and is well beyond the scope of the present study. Further investigations into these issues would be a fruitful area for future research.