In this study we analyze dealer exit, survival, and competitive equilibrium in the NASDAQ Stock Market using data from a unique period that entails major changes in regulatory and competitive environments. We decompose the forces that affect dealer survival into market factors and dealer attributes. Market factors encompass those variables that affect the demand for and profitability of dealer services as a whole. Variation in survival probability across dealers results mainly from their competitive advantages in business strategies, information, quote aggressiveness, access to order flow, and economies of scale. On the whole, our results suggest that dealer markets exhibit a Darwinian survival of the fittest.
Vol. 49 No. 3 - August 2014
We compare the liquidity providing behavior of NASDAQ market makers in 2010 to their behavior in 2004. We examine how frequently market makers are at the inside quote, what market and stock specific factors influence market makers’ behavior, and the relation between market maker participation and intraday bid-ask spread patterns. We observe a decrease in the percent of the trading day dealers’ quote at the inside, a decline in the number of market makers, and a decrease in the influence market makers have on intraday spread patterns. The results suggest that the role of NASDAQ market makers declines over time.
During the Flash Crash on May 6, 2010, a short period of high stock market volatility, some stock prices declined to $0.01, while others increased to $100,000. Examining Intermarket Sweep Orders (ISOs) before, on, and after May 6, we find that ISO use is substantially higher on May 6. For those stocks whose prices fell the most, over 65% of the sell volume comes from ISOs. During the price recovery period for these stocks, about 53% of the buy volume comes from ISOs. We believe that the unusual behavior of ISOs contributed to the sudden drop and recovery of the market.
We investigate whether market makers with inventory concerns are compensated with subsequent monthly returns in the cross-section. We find a significant negative relation between order flows and monthly returns, “the order flow effect,” suggesting that market makers lower prices for stocks with sell order flows and demand a reward in the form of higher expected returns. Further, the order flow effect is stronger for high-volatility or high-volume stocks for which market makers have serious inventory concerns. Funding liquidity of market makers also affects the order flow effect. Finally, our finding is independent of existing regularities and robust to the decimalization.
This paper investigates the influence of information asymmetry on the cross-sectional variation of volume-return relation. We find that the dynamic volume-return relation within medium-size trades has the most significant response to the degree of information asymmetry. We also show that the effect of information asymmetry on the volume-return dynamics migrates to small-size trades in recent years, especially in larger stocks. These results are consistent with the notion that informed traders prefer medium-size trades and this preference has shifted to small-size trades. Our findings highlight the importance of incorporating informed traders’ trade-size decision in the examination of the dynamic volume-return relation.
The financial press suggests that information is commonly leaked prior to analyst recommendations. We examine the impact that three regulatory actions (Regulation Fair Disclosure, Global Analysts Research Settlement, and the legal case against Galleon Group) have on information leakage prior to analyst recommendations. We find that all three regulatory actions have significantly reduced the leakage of information prior to analyst recommendations, even after controlling for several characteristics that explain the variation in information leakage. Our results are robust when applying an alternative method of measuring information leakage, and when forming various samples of analyst recommendations based on different criteria.
We examine the dynamic relations among market returns, market (MV), and idiosyncratic (IV) around business cycles. Compared to the conventional view, which treats MV and IV separately, we first find that excess return on the market anticipates negative MV and IV, suggesting market return’s role as an economic indicator, with the relation stronger in recessions. Second, IV helps predict positive MV, mainly in early part of recessions, suggesting a dynamic evolution from IV to MV. Third, MV helps predict negative IV, suggesting MV may substitute IV to some extent.
The value of exchange traded fund (ETF) assets has increased from $66 billion in 2000 to almost a trillion dollars in 2010. We use this massive expansion in ETF assets to study what drives ETF flows. Using a data set of over 500 ETFs from 2001 to 2010, we show that ETF investors chase returns in the same way as mutual fund investors. While there is an active debate about whether return chasing by mutual fund investors represents the pursuit of superior talent, the existence of return chasing in this passively managed environment should not represent a search for skilled managers. We also show that ETF flows increase following high volume, small spreads, and high price/net asset value ratios. Finally, we find little evidence of superior market timing in ETF flows. Our results suggest that return chasing in both mutual funds and ETFs is more likely the result of naïve extrapolation bias on the part of investors that has contributed to the growth of the ETF industry.