The Impact of Market Maker Concentration on Adverse-Selection Costs for NASDAQ Stocks

Abstract

We examine the impact of market maker concentration on adverse-selection costs for NASDAQ stocks and find that more market makers results in lower costs. Furthermore, this reduction in adverse-selection exceeds the overall reduction in spreads that is attributable to market maker competition. We hypothesize that order flow internalization is increasing in market makers and allows for greater information production, and is an explanation for our findings. Our results provide an explanation for the puzzle documented by previous work that finds that adverse-selection costs for NASDAQ tend to be lower than for the New York Stock Exchange, while spreads tend to be higher.

Keywords: Market microstructure, adverse selection costs, bid-ask spreads

JEL Classification: G14, G18