Dealer market structure, outside competition, and the bid-ask spread

Abstract We investigate the linkages between the number of dealers making markets in a security, the extent of outside (or nondealer) competition, and the market bid ask spread for NASDAQ NMS stocks. The investigation is guided by a model that emphasizes dealers' interactions as their inventories change, and predicts that the extent of outside competition limits the bid-ask spread and the number of dealers. We hypothesize that the extent of outside market making capital in a stock is related to that stock's institutional holdings. Evidence shows that the extent of institutional holdings relative to trading volume proxies for outside competition. For stocks with little outside competition, the spread is large even though the number of dealers is also larger than for comparable stocks. The component of the spread related to outside market making capital is economically significant (about 1 2 to 1 percent of price). The composition of volume as to trade size and trade frequency, which is related to the level of institutional holdings, also influences the spread.

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