The Costs of Trading Nasdaq Issues: The Impact of Limit Orders and ECN Quotes

Abstract:     
On January 20, 1997, the Securities and Exchange Commission began requiring Nasdaq market makers to execute or display customer limit orders. In addition, Nasdaq began displaying quotes placed by market makers to execute or display customer limit orders. In addition, Nasdaq began displaying quotes placed by market makers in Electronic Communication Networks (ECN). We assess the impact of these new rules on various measures of trading costs, including quoted and effective spreads. We also use individual dealer quotes to examine the strategic response of market makers to their increased ability to post wider spreads (through a relaxation in the Excess Spread Rule) and to offer minimum quote sizes of 100 rather than 1,000 or 500 shares. Our results indicate that trading costs fell dramatically in the presence of these new rules. Trade sizes have also fallen significantly, particularly among trades executed through the Small Order Execution System. However, the net effect of incorporating limit orders and ECN quotes translates into savings of approximately $1.6 million per day among the first 100 stocks traded under the new rules.

JEL Classification: G12, G14

working papers series