The Quality of ECN and Nasdaq Market Maker Quotes

Abstract

This paper compares the quality of quotes submitted by electronic communication networks~ECNs! and by traditional market makers to the Nasdaq quote montage. An analysis of the most active Nasdaq stocks shows that ECNs not only post informative quotes, but also, compared to market makers, ECNs post quotes rapidly and are more often at the inside. Additionally, ECN quoted spreads are smaller than dealer quoted spreads. The evidence suggests that the proliferation of alternative trading venues, such as ECNs, may promote quote quality rather than fragmenting markets. Moreover, the results suggest that a more open book contributes to quote quality. THIS PAPER EXAMINES THE QUALITY of quotes posted by electronic communication networks~ECNs! and by Nasdaq market makers for actively traded Nasdaq stocks. An important dimension of quote quality is price leadership, or price discovery, which is accomplished by timely submission of informative quotes. An informative quote ref lects an asset's unobservable full-information value or fundamental value. Full-information value is distinct from the observable price, which can be decomposed into two components, one ref lecting fullinformation value and one ref lecting transitory effects. The latter consists of price movements due to the bid-ask bounce, temporary order imbalances, inventory adjustments, and rounding effects.A study of the quality of ECN and Nasdaq market maker quotes is important because there are important differences between the two trading environments. ECNs are computer-mediated markets that disseminate limit orders from their subscribers and execute trades by matching orders. Instinet and Island are the two most liquid ECNs. Instinet was the first ECN and is mainly used by institutional traders and Nasdaq market makers as an alternative trading venue. By contrast, day traders often use Island to lay off

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