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Transaction Costs in Dealer Markets: Evidence From The London Stock Exchange

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  • Peter C. Reiss
  • Ingrid M. Werner
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    Abstract

    This paper describes regularities in the intraday spreads and prices quoted by dealers on the London Stock Exchange. It develops a measure of spread-related transaction costs, one that recognizes dealers' willingness to price trades within their quoted spreads. This measure of transaction costs shows that trading costs are systematically related to a trade's size, characteristics of the trading counterparties, and security characteristics. Customers pay the full spread on small trades while medium to large trades receive more favorable execution. Market makers only discount very large customer trades while dealers regularly discount medium to large trades. Inter-dealer trades generally receive favorable execution, and discounts increase in size. Market makers do not discount trades with each other over the phone, but do discount when trading anonymously using inter-dealer-brokers. Quoted and touch spreads are falling in the number of market makers. The rate of decline is interpreted as reflecting economies of scale in market making.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4727.

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    Date of creation: May 1994
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    Publication status: published as The Industrial Organization and Regulation of the Securities Industry, Andrew Lo, ed. University of Chicago Press, 1996. ISBN# 0-226-48847-0, pp. 125
    Handle: RePEc:nbr:nberwo:4727

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    17. De Jong, F. & Nijman, T. & Roell, A., 1993. "A Comparison of Cost of Trading French Shares on the Paris Bourse and on SEAQ International," Papers, Tilburg - Center for Economic Research 9329, Tilburg - Center for Economic Research.
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    Cited by:
    1. Naik, Narayan Y. & Yadav, Pradeep K., 2003. "Do dealer firms manage inventory on a stock-by-stock or a portfolio basis?," Journal of Financial Economics, Elsevier, Elsevier, vol. 69(2), pages 325-353, August.
    2. Levin, Eric J. & Wright, Robert E., 2004. "Estimating the profit markup component of the bid-ask spread: evidence from the London Stock Exchange," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 44(1), pages 1-19, February.
    3. Vitale, Paolo, 1998. "Two months in the life of several gilt-edged market makers on the London Stock Exchange," Journal of International Financial Markets, Institutions and Money, Elsevier, Elsevier, vol. 8(3-4), pages 299-324, December.
    4. Marco Pagano, 1998. "The Changing Microstructure of European Equity Markets," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 04, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    5. Huang, Roger D. & Stoll, Hans R., 1996. "Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE," Journal of Financial Economics, Elsevier, Elsevier, vol. 41(3), pages 313-357, July.
    6. Vogler, Karl-Hubert, 1997. "Risk allocation and inter-dealer trading," European Economic Review, Elsevier, Elsevier, vol. 41(8), pages 1615-1634, August.
    7. Lyons, Richard K., 1997. "A simultaneous trade model of the foreign exchange hot potato," Journal of International Economics, Elsevier, Elsevier, vol. 42(3-4), pages 275-298, May.

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