Dealer Versus Auction Markets: A Paired Comparison of Execution Costs on NASDAQ and the NYSE

Abstract

Execution costs for a sample of Nasdaq stocks significantly exceed those for a matched sample of NYSE stocks. Execution costs are measured by the quoted spread, the effective spread (which accounts for trades inside the quotes), the realized spread (which measures revenues of suppliers of immediacy), the Roll (1984) implied spread, and a measure of post-trade variability. By these measures the Nasdaq execution cost is twice the NYSE cost. The difference is not due to differences in the stocks, for we match on stock characteristics. Nor is it due to the presence of informed traders, for we find that Nasdaq dealers lose a smaller fraction of the quoted spread than do NYSE suppliers of immediacy. We rule out differences in the frequency of even eighth quotes. The increase in affirmative obligation on dealers and the rise in institutional trading are eliminated as possible sources of the differential. Partial explanations are provided by the fact that Nasdaq dealers do not charge commissions to institutions and that limit orders cannot compete with dealers in Nasdaq. We conclude that the primary explanation is the internalization and preferencing of order flow on Nasdaq that limit the incentive to narrow spreads. Execution costs are large because there has been little incentive to reduce them.

JEL Classification: D44, G19