Why is There Heterogeneity Among Dealers' Behavior During the NASDAQ Preopening Session?

Abstract

Order preferencing enables a market-maker to execute captive order flow off the primary market. This practice is known to generate wider spreads due to its anti-competitive effects. It also increased inventory risks for dealers. The Nasdaq preopening offers a laboratory to test whether market-makers use non-binding prices as a tool to control their inventory position. We find that the most preferred category of market-makers - called 'the wholesalers' - participate the most actively in the communication game taking place during the preopening session. This category contributes, however, the least to the price discovery process. Besides, unlike other dealers, wholesalers communicate more on stocks with a high degree of order preferencing and are more likely to be on the inside spread when communicating more. These findings suggest that they initiate signals to reduce inventory imbalances due to preferencing. Finally, we find that the reversal of the wholesalers' price is the largest at the opening, which supports the hypothesis that they are the most exposed to inventory imbalances. Moreover, the best prices (the NBBO) also have a transitory component at the opening, which corroborates our main hypothesis that the Nasdaq non-trading mechanism incorporates inventory information into prices.

Keywords: Nasdaq, Order Preferencing, Preopening, Inventory, Price-reversal