The Market for Market-Making

Abstract

Nasdaq market-makers can adopt new stocks or abandon old ones with almost no entry or exit costs. Under these circumstances, the theory of contestable markets predicts that market-making concentration in individual stocks should be unrelated to the profits dealers earn trading those stocks. However, I find that after adjusting for factors believed to determine spreads, market-maker concentration is a highly significant determinant of trading costs. The problem is that entry does not bring order flow. I show that dealers make markets in stocks in which they are likely to receive order flow either through purchase agreements or through internalization. A dealer's brokerage clientele, geographic location, and participation in underwriting syndicates are all determinants of his choice of stocks in which to make markets.

JEL Classification: G10, G24, L11, L13, L80