Do Dealers Infer Information from Order Flow?
40 Pages Posted: 22 Oct 2004
Date Written: October 2004
I examine strategic behavior amongst dealers in the NASDAQ market to identify whether they infer information from order flow. In particular, I ask: (a) is there a lead quote-setting dealer in each security and if so, are the quotes and/or trades of this leader informative?, (b) do others making market in the same security free-ride informative quotes?, and (c) what are some information signals that followers infer to identify the leader? I find that: (a) there is typically a quote-setting leader for each security who could be either a market maker or an Electronic Communications Network, (b) the quotes of this leader are followed by others making market in the same security, and (c) the lead dealer is usually the one that spends the highest percentage of time on the inside market, i.e., posts inside quotes. Trade volume is another (albeit weaker) information signal. My findings suggest that directing trade to the leader may be more advantageous to investors than randomly choosing a dealer for trade execution.
Keywords: Dealer Market, Quote Leadership, Error Correction, Co-Integration, NASDAQ, Information Signal
JEL Classification: C32, G14
Suggested Citation: Suggested Citation