Trading Costs of Public Investors with Obligatory and Voluntary Market-Making: Evidence from Market Reforms

Abstract

In 1997, the London Stock Exchange, like NASDAQ, allowed the public to compete directly with dealers in a subset of stocks through the submission of limit orders. However, unlike NASDAQ, for these stocks, London also removed the obligation of dealers to quote firm two-way prices, and became a voluntary dealer network competing with a centralized limit order book. In the context of the important differences between the reforms on London and NASDAQ, this London based study addresses several important questions of academic, regulatory and practitioner interest that could not hitherto be examined through U.S. based studies. First, we investigate how the change from obligatory to voluntary market-making affects the provision of financial intermediation services. In particular, we examine the effect of binding market maker obligations on price-stabilisation, and the effect of binding market maker obligations on the adverse selection losses that market makers make in dealing with informed investors. In this context, we also examine the effect of competition and the contestability of markets in competing and non-competing segments, and analyse how the lack of pre-trade quote-transparency, and the resultant increased search costs, affect trading costs. Second, since a major benefit of the London and NASDAQ reforms was the opportunity afforded to "public" investors to earn the spread by posting limit orders, instead of always paying the spread by demanding liquidity, we analyse how the premium charged by individual or institutional "public" investors for supplying liquidity, and the adverse selection losses they face, are different from those of market intermediaries.