The Declining Role of NASDAQ Market Makers

Published date01 August 2014
Date01 August 2014
The Financial Review 49 (2014) 461–480
The Declining Role of NASDAQ Market
Jared Egginton*
Louisiana TechUniversity
Wecompare the liquidity providing behavior of NASDAQ market makers in 2010 to their
behavior in 2004. We examine how frequently market makers are at the inside quote, what
market and stock specific factors influence market makers’ behavior,and the relation between
market maker participation and intraday bid-ask spread patterns. We observe a decrease in
the percent of the trading day dealers’ quote at the inside, a decline in the number of market
makers, and a decrease in the influence market makers have on intraday spread patterns. The
results suggest that the role of NASDAQmarket makers declines over time.
Keywords: market structure, dealer markets, NASDAQ market makers, bid-ask spreads
JEL Classifications: G14, G18
1. Introduction
Market makers provide valuable services to marketsby providing liquidity when
no trading counterparty is immediately available. However, unlike the NYSE and
Corresponding author: Department of Economics and Finance, College of Business, P.O. Box 10318,
Louisiana Tech University, Ruston, LA 71272; Phone: (318) 257-3571; Fax: (318) 257-4253; E-mail:
I would like to thank the editor, Robert Van Ness, and an anonymous referee for their helpful comments
and suggestions.
C2014 The Eastern Finance Association 461
462 J. Egginton/The Financial Review 49 (2014) 461–480
other designated specialist markets, dealers on NASDAQ have no explicit obligation
to maintain a fair and orderly inside market. In recent years, NASDAQ market makers
face an increase in competition from new market participants such as high frequency
traders engaging in market making strategies.
We study the role of the NASDAQ market maker in 2010 and compare it to
the role in 2004. We compare the following across the 2004 and 2010 periods: the
frequency with which NASDAQ market makers are at the inside quote; the market
and stock specific factors which influence market makers’ behavior; the number of
market makers who actively quote; and the relation between market maker quoting
activity and intraday bid-ask spread patterns.
We classify all bid and ask quotes according to whether or not a quote reflects
the trading interest of a NASDAQ market maker or another market participant. We
calculate the inside bid, and ask and classify each side of the spread as reflecting
the trading interest of the dealer or other market participants. We use the quote
information in the 2004 and 2010 periods to determine if market makers have a
greater relative impact on intraday quoted spreads across periods. Wealso look at the
number of market makers across periods.
We find that the percentage of time market makers quote at the inside spread
declines substantially from 2004 to 2010. In 2004, the percentage of the trading day
that market makers quote at the inside bid (ask) is 60% (62%) compared to 2010
where NASDAQ dealers quote at the inside bid (ask) is just 12% (11%). The number
of active market makers declines from an average of 12 dealers per stock in 2004 to
8 dealers per stock in 2010. We also find evidence that the influence market makers
have on intraday variations in the bid-ask spread declines over time.
While we observe a decline in dealer provided liquidity from 2004 to 2010 for
both active and lightly traded securities, this decline is less severe in less actively
traded stocks. In 2010, dealers quote more competitively in stocks with less trading
activity and higher return volatility,suggesting that dealers may still provide valuable
liquidity providing services.
2. Background/hypotheses
2.1. The changing role of NASDAQ market makers
Nonintermediated trading platforms based on an open electronic limit order
book have become increasingly prevalent.This increase in nonintermediated markets
suggests the viability of a nonhuman intermediated market structure. Glosten (1994)
develops a model of an open electronic limit order book. His model suggests that
an electronic limit order structure is “inevitable” in that it should be a center of
significant trading volume, and other market structures, including anonymous dealer
markets, will have a difficult time competing with the electronic limit order book’s
market structure. Using an experimental electronic asset market without designated
liquidity providers, Bloomfield, O’Hara and Saar (2005) find evidence that supports

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