What Explains the Bid-Ask Spread Decline after Nasdaq Reforms?

Abstract

This paper examines whether the decrease in bid-ask spreads on Nasdaq after the 1997 reforms is due to a decrease in market-making costs and/or an increase in market competition for order flows. Unlike previous studies, we jointly examine how competition and trading costs affect bid-ask spreads. In addition, we separate the effects of informed trading and liquidity costs on bid-ask spreads. Informed trading cost is directly estimated for each Nasdaq stock using a Bayesian theoretic model. Empirical results show that market-making costs and competition significantly affect bid-ask spreads. The post-reform decrease in bid-ask spreads is largely due to both an increase in competition and a decrease in informed trading and liquidity costs on Nasdaq.