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|کد مقاله||سال انتشار||تعداد صفحات مقاله انگلیسی||ترجمه فارسی|
|14023||2006||24 صفحه PDF||سفارش دهید|
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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : Journal of Financial Intermediation, Volume 15, Issue 1, January 2006, Pages 108–131
We analyze data provided by NASDAQ to examine how quote aggressiveness affects dealer market share and whether the practice of internalization mitigates the impact of quote aggressiveness. Our empirical results show that although internalization does not reduce the impact of price aggressiveness on dealer market share, it mitigates the impact of size aggressiveness. This result suggests that although internalization may not affect the dealer's incentive to post aggressive prices, it may reduce the incentive to post large depths. We find that aggressive quotes are more effective in raising dealer market share in stocks with a less competitive (more concentrated) market structure. Our results also show that the effective spread is wider (narrower) for stocks with a smaller price (size) elasticity of dealer market share.
Brokers and dealers on NASDAQ frequently internalize their order flow or route through payment for order flow agreements. Internalization is the direction of order flow by a broker-dealer to an affiliated market maker. Payment for order flow agreement involves either direct monetary payments or in-kind goods and services provided by dealers to brokers in return for routing customer orders. Chung et al. (2004) show that a large portion of NASDAQ order flow is internalized and stocks with greater internalized trades exhibit wider spreads.1 Although a number of prior studies show either analytically or with experimental data that internalization exerts a negative impact on dealer competition and market quality, there is relatively little empirical evidence on the issue. In this study, we examine whether internalization adversely affects market quality by reducing dealers' incentives to post aggressive quotes. To address this question, we first investigate the relation between dealer market shares and quote aggressiveness. Whether dealers who quote more aggressively have larger market shares is an interesting question given the fact that a significant portion of NASDAQ volume is internalized. If dealers who quote aggressively have the same market share as dealers who do not quote aggressively, dealers would have little incentives to post competitive quotes. If dealers do not post competitive quotes, investors are likely to incur larger trading costs. We then address a related, perhaps more intriguing question whether inter-stock differences in internalization can explain inter-stock differences in the elasticity of dealer market share with respect to quote aggressiveness. If the practice of internalization reduces the incentive to quote aggressively because such practice lowers the effect of quote aggressiveness on market share, then internalization may have an adverse effect on market quality. Prior studies suggest that order preferencing (i.e., internalization and payment for order flow) reduces the incentive to post aggressive quotes. Godek (1996) holds that order preferencing weakens the linkage between quote aggressiveness and order flow and diminishes the incentive to narrow the spread. Huang and Stoll (1996) and Bessembinder (1999) suggest that internalization and payment for order flow are likely sources of wider spreads on NASDAQ. Bloomfield and O'Hara (1998) show that order preferencing may significantly degrade market performance if preferenced orders are a large share of the market or are received by virtually all market makers. Ackert and Church (1999) provide experimental evidence that payment for order flow and internalization limit dealers' incentive to improve price. Christie and Schultz (1994), Battalio and Holden (1996), Dutta and Madhavan (1997), and Kandel and Marx, 1997 and Kandel and Marx, 1999 suggest that order preferencing facilitates collusion and thus results in wider bid–ask spreads.2 Although prior studies offer both analytical predictions and experimental evidence regarding the effects of order preferencing on execution costs, they offer limited evidence as to the relation between quote aggressiveness and market share and whether this relation varies with order preferencing. Only recently have studies begun to shed some light on the direct empirical link between quote aggressiveness and market share. Blume and Goldstein (1997) find that non-NYSE market makers attract more order flow for NYSE stocks when they post the best available quotes. Smith (1999) shows that the bulk of inter-dealer orders on NASDAQ are routed on the basis of the quotes of the potential recipients. Bessembinder (2003) finds substantial quote-based competition for order flow in NYSE-listed stocks. Bessembinder also shows that off-NYSE liquidity providers use quotations as a selective signaling device to indicate whether they are prepared to give better than normal trade executions and order routing responds to these signals. Klock and McCormick (2002) show that dealer market share increases with quote aggressiveness on NASDAQ. The authors also find that stocks with a higher Herfindahl-index (i.e., less competitive market structure) exhibit a smaller effect of quote aggressiveness on market share. They interpret the latter result as evidence that order preferencing weakens the effectiveness of aggressive quoting on order flow (given the assumption that stocks with large Herfindahl-indexes also have high levels of order preferencing). Because the authors do not utilize data on order preferencing, however, the study fails to show any direct effect of order preferencing on the value of aggressive quotes. To date, no prior study provided direct empirical evidence on whether order preferencing lowers the elasticity of dealer market share with respect to quote aggressiveness. In the present study, we analyze data provided by NASDAQ to examine how quote aggressiveness affects dealer market share and whether the practice of internalization mitigates the impact of dealer quotes on market share. Considering the academic and regulatory debates on whether internalization degrades market quality,3 it may be of great interest to both regulatory authorities and the general public to know how internalization affects the dealer's incentive to quote aggressively. Our empirical results show that aggressive quotes help increase dealer market share, despite the fact that a large proportion of NASDAQ order flow is internalized. We find that while the impact of price aggressiveness on dealer market share does not vary with the extent of internalization, the impact of size aggressiveness is significantly and negatively related to internalization. These results suggest that although internalization may not affect the dealer's incentive to post aggressive prices, it may reduce the incentive to post large depths. Contrary to the finding of Klock and McCormick (2002) from the pre-reform data, we show that aggressive quotes are more effective in raising dealer market share in stocks with less competitive (more concentrated) market structure from our post-reform data. Our results also show that the effective spread is wider (narrower) for stocks with a smaller price (size) elasticity of dealer market share. The paper is organized as follows. Section 2 describes data sources and sample selection procedures and presents descriptive statistics. Section 3 analyzes the effects of price and size aggressiveness on dealer market share. Section 4 examines whether the practice of internalization mitigates the impact of quote aggressiveness on dealer market share. Section 5 analyzes the effect of the elasticity of dealer market share on the effective spread. Section 6 provides a brief summary and concluding remarks.