Competition and Market Structure of National Association of Securities Dealers Automated Quotations

Youngsoo Kim and Vikas Mehrotra

International Review of Finance, 2007, vol. 7, issue 3‐4, 143-160

Abstract: In this paper, we study the relation among market structure, trading costs, and competition in National Association of Securities Dealers Automated Quotations (NASDAQ). In particular, we address the following questions: Do NASDAQ dealers exercise market power and extract economic rents in setting bid‐ask spread? How persistent is the market power of dominant dealers? Our estimate of the rent is approximately ¢8.76, or 0.54% of stock price. The half‐life of the persistence of this rent is approximately 20 months for the entire sample, while the half‐life of younger stocks tend to be shorter than those of more mature stocks. Our result supports Schultz: NASDAQ dealers make markets only for stocks where they have competitive advantages in accessing order flow and in information. It might take a while before a market maker poses effective competition to existing dominant market makers. In the meantime, incumbent market makers are able to exercise market power and appear to earn abnormally large profits.

Date: 2007
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