Exit, Survival, and Competitive Equilibrium in Dealer Markets

Date01 August 2014
Published date01 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
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.
C2014 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.

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