Exit, Survival, and Competitive Equilibrium in Dealer Markets

• Author: Chairat Chuwonganant,Kee H. Chung
• DOI: http://doi.org/10.1111/fire.12050
• Date: 01 August 2014
• Published date: 01 August 2014

The Financial Review 49 (2014) 435–460

Exit, Survival, and Competitive

Equilibrium in Dealer Markets

Kee H. Chung∗

State University of New York(SUNY) at Buffalo, Chung-Ang University

Chairat Chuwonganant

Kansas State University

Abstract

In this study we analyze dealer exit, survival,and competitive equilibrium in the NASDAQ

Stock Market using data from a unique period that entails major changes in regulatory and

competitive environments. We decompose the forces that affect dealer survival into market

factors and dealer attributes. Market factors encompass those variables that affect the demand

for and profitability of dealer services as a whole. Variation in survival probability across

dealers results mainly from their competitive advantages in business strategies, information,

quote aggressiveness, access to order flow,and economies of scale. On the whole, our results

suggest that dealer markets exhibit a Darwinian survival of the fittest.

Keywords: market structure, dealer competition, competitive advantages, quote aggressive-

ness, bid-ask spread, market share, survival probability,exit decision

JEL Classifications: G14, G18

∗Corresponding author: Department of Finance and Managerial Economics, School of Management,

State University of NewYork (SUNY) at Buffalo, Buffalo, NY 14260; Phone: (716) 645-3262; Fax: (716)

645-3823; E-mail: keechung@buffalo.edu.

The authors thank the editor (Robert Van Ness), two anonymousreferees, Frank Hatheway, Alex Kurov,

Pok-sang Lam, Matthew Spiegel, Kuo Tan,Jennifer Wu, Sean Yang, WoongsunYoo, session participants

at the 2011 Financial Management Association conference, and colleagues at SUNY-Buffalo and Kansas

State University for valuable discussion, comments, and suggestions. The usual disclaimer applies.

C2014 The Eastern Finance Association 435

436 K. H. Chung and C. Chuwonganant/The Financial Review 49 (2014) 435–460

1. Introduction

This paper analyzes the industrial organization of dealer markets. A dealer firm’s

entry and exit decisions may be viewed as adjustments to a new equilibrium that are

dependent on a variety of factors. The probability of a dealer firm’s survival or exit

in a given interval of time is likely to be a function of both the market environment

and dealer attributes. There are two types of dealer exit decisions. A dealer firm may

exit the market entirely, quitting its market-making operation in all stocks. More

often than not, a dealer firm may exit the market partially,quitting its market-making

operation only in select stocks. In this study, we analyze the dealer firm’s exit and

survival in the NASDAQ Stock Market using data from a unique period that entails

major changes in regulatory and competitive environments.

The NASDAQ Stock Market went through a major transformation during the

past decade. The number of stocks on NASDAQ declined significantly due in large

part to the delisting of many high-technology stocks after the dot.com bubble. For

instance, the number of stocks listed on NASDAQ in our study sample went down

from 5,931 in 1999 to 3,509 in 2006. In addition, there were significant decreases

in the bid-ask spread of NASDAQ stocks and dealer market share due to a number

of regulatory changes and market-wide changes in competitive environments (e.g.,

decimalization, SEC Rule 605, SuperMontage, and the proliferation of electronic

communication networks [ECN]).1We perform an empirical analysis of dealer exit,

survival, and competitiveequilibrium by looking at how NASDAQ dealers responded

to these shocks.2Toour knowledge, this study is the first to analyze the consequences

of these events in the NASDAQ Stock Market.

We show that as the number of stocks and the bid-ask spread on NASDAQ

declined and competition from ECNs increased, many dealers exited the market

entirely, resulting in a significant reduction in the number of dealers on NASDAQ.

For instance, the number of dealers went down by 57% from 516 in 1999 to 221 in

2006. Those dealers with competitive advantagessurvived and each of these surviving

dealers handled an increasingly larger number of stocks. The mean number of stocks

that were handled by NASDAQ dealers increased by more than 120% from 112 in

1999 to 248 in 2006. As a result, the mean number of dealers in each stock actually

increased from 10 in 1999 to 14 in 2006, despite the considerable decrease in the

total number of dealers.

We show that dealers were more likely to survive when their market-making

businesses were evenly distributed across stocks, when theymade markets in a larger

number of stocks, and when they had larger market shares. Weinterpret these results

as evidence that dealers with diversified market-making operations across stocks

1See Bessembinder (2003c), Zhao and Chung (2007), and Chung and Chuwonganant (2009).

2In this paper we use the terms “dealers” and “market makers” synonymously as those who compete for

customer order flow by displaying buy and sell quotations for a guaranteed number of shares.