Footnote:
In: Journal of Empirical Finance, Forthcoming
Description:
Two hypotheses have been advanced to explain why spreads on NASDAQ were substantially higher than those on the NYSE in the 1990s: quot;collusionquot; and quot;preferencing and payment for order flowquot;. We present data on all actively traded stocks in these markets of relative effective spreads (RES), aggregated monthly over 1987-1999 and advance a third hypothesis: NASDAQ quot;SOES-day-tradingquot;. We estimate NASDAQ and NYSE informed-trade losses and gains to market makers and other liquidity providers on six trade sizes, and find that losses on trades we ascribe to SOES day traders were substantially greater than those on other trades, offset somewhat by gains from small-trade-size investors. NASDAQ market makers' response to these losses and additional operations costs incurred to reduce the losses resulted in greater RES and increased trading within the best quotes, predominantly on larger trade sizes. The data are consistent with the quot;SOES-day-tradingquot; hypotheses, but not with the other two. Furthermore, the mandatory SOES quot;experimentquot; provides insights into the negative effects of automated trading systems (such as ECNs, which now dominate NASDAQ) when their design does not adequately consider opportunistic traders