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Imperfect Competition in Financial Markets: An Empirical Study of Island and Nasdaq

  • Bruno Biais


    (Toulouse School of Economics (IDEI, CNRS, CRM), Toulouse University, 31000 Toulouse, France)

  • Christophe Bisière


    (Toulouse School of Economics (IAE, IDEI, CRM), Toulouse University, 31000 Toulouse, France)

  • Chester Spatt


    (Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213)

The competition between Island and Nasdaq at the beginning of the century offers a natural laboratory to study competition between and within trading platforms and its consequences for liquidity supply. Our empirical strategy takes advantage of the difference between the pricing grids used on Island and Nasdaq, as well as of the decline in the Nasdaq tick. Using the finer grid prevailing on their market, Island limit order traders undercut Nasdaq quotes, much more than they undercut one another. The drop in the Nasdaq tick size triggered a drop in Island spreads, despite the Island tick already being very thin before Nasdaq decimalization. We also estimate a structural model of liquidity supply and find that Island limit order traders earned rents before Nasdaq decimalization. Our results suggest that perfect competition cannot be taken for granted, even on transparent open limit order books with a very thin pricing grid.

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Article provided by INFORMS in its journal Management Science.

Volume (Year): 56 (2010)
Issue (Month): 12 (December)
Pages: 2237-2250

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Handle: RePEc:inm:ormnsc:v:56:y:2010:i:12:p:2237-2250
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  17. Bacidore, Jeffrey & Battalio, Robert H. & Jennings, Robert H., 2003. "Order submission strategies, liquidity supply, and trading in pennies on the New York Stock Exchange," Journal of Financial Markets, Elsevier, vol. 6(3), pages 337-362, May.
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  19. Chung, Kee H. & Chuwonganant, Chairat & McCormick, D. Timothy, 2004. "Order preferencing and market quality on NASDAQ before and after decimalization," Journal of Financial Economics, Elsevier, vol. 71(3), pages 581-612, March.
  20. Goldstein, Michael A. & Shkilko, Andriy V. & Van Ness, Bonnie F. & Van Ness, Robert A., 2008. "Competition in the market for NASDAQ securities," Journal of Financial Markets, Elsevier, vol. 11(2), pages 113-143, May.
  21. Sandas, Patrik, 2001. "Adverse Selection and Competitive Market Making: Empirical Evidence from a Limit Order Market," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 705-34.
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