The Declining Role of NASDAQ Market Makers

• DOI: http://doi.org/10.1111/fire.12045
• Published date: 01 August 2014
• Author: Jared Egginton
• Date: 01 August 2014

The Financial Review 49 (2014) 461–480

The Declining Role of NASDAQ Market

Makers

Jared Egginton*

Louisiana TechUniversity

Abstract

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:

egginton@latech.edu.

I would like to thank the editor, Robert Van Ness, and an anonymous referee for their helpful comments

and suggestions.

C2014 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