Nasdaq Case Study
Quoting Convention of NASDAQ Dealers Prompts a Justice Department Probe Michael Baye and Patrick Scholten prepared this case study to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case is a condensed and slightly modified version of the public copy of the Complaint of Violation Statement, Civil Action No. 96 CIV 5313, dated July 17, 1996 in the United States of America v. Alex Brown & Sons Inc. , et al.
NASDAQ The NASDAQ Stock Market, Inc. (NASDAQ) is the second largest securities market (measured by dollar value of trading) in the United States.NASDAQ market makers have offices in various states. Their market-making activities, and the violation alleged, affect investors located throughout the United States. During the time period covered, the companies in question have traded substantial numbers of shares of NASDAQ stock across state lines in a continuous and uninterrupted flow of interstate trade and commerce.
The activities of each company as described here have been within the flow of, and have substantially affected, interstate commerce. POTENTIAL VIOLATIONThe companies in question are major “market makers” in NASDAQ stocks. Market makers establish their NASDAQ quotes in a particular stock by simultaneously quoting prices at which they are willing to buy and sell particular NASDAQ stocks. The quote at which an individual market maker is willing to buy a particular stock is known as its “bid”; the quote at which it is willing to sell is known as its “ask. ” A market maker’s bid is always lower than its ask, and the difference between the two is known as its “dealer spread.
” There are at least two market makers in each NASDAQ stock.These market makers are purportedly independent and purportedly compete against other market makers, by, among other ways, quoting bid and ask prices on NASDAQ for particular stocks. The market maker’s bid- and ask-prices are organized and displayed on NASDAQ’s computerized quotation system. The market makers use this computer system to change and update their respective bid and ask prices and to continuously communicate their prices to the other market makers in particular stocks. At any given time, one or more than one market maker may have the best bid or ask price in a particular stock on NASDAQ.The highest bid price is known as the “inside bid”; the lowest ask price is known as the “inside ask.
” The difference between the “inside bid” (the highest price offered by any market maker to buy that stock) and the “inside ask” (the lowest price offered by any market maker to sell that same stock) is referred to as the “inside spread. ” Market makers earn money from the difference between the bid and ask, or the inside spread. Market makers therefore have an incentive to maintain wider inside spreads in NASDAQ stocks than would exist in a competitive market.The width of the inside spread in a stock has a direct impact on investors in NASDAQ stocks. The wider the inside spread, the greater the transaction costs for buying and selling NASDAQ stocks. Beginning at least as early as 1989, a common understanding might have arose among the companies listed in Appendix A companies and other NASDAQ market makers concerning, among other things, the manner in which bid and ask prices would be displayed on NASDAQ (the “quoting convention”).
Under the quoting convention, stocks with a dealer spread of 3/4 point or greater are quoted in even-eighths (quarters).Under the quoting convention, market makers use odd-eighth fractions in their bid and ask prices only if they first narrow their dealer spread in the stock in question to less than 3/4 of a point. The listed companies and other market makers may have reached a common understanding to adhere to the quoting convention. This understanding is evidenced by, among other things, the following facts: a. For a significant number of major stocks traded on NASDAQ, all of which have prevailing dealer spreads of 3/4s of a point or greater, there has been an almost complete absence of bid or ask price quotes in odd-eighths; b.The companies here and other market makers have used and continue to use peer pressure to ensure compliance with the common understanding by making it known throughout the industry that it is “unethical” or “unprofessional” for a market maker to “break the spread” by using odd-eighth quotes in stocks with dealer spreads of 3/4s of a point or greater and by accusing market makers who do so of “making a Chinese market”; c.
The companies here and other market makers have taken actions to enforce compliance with the common understanding and to coerce non-complying market makers to adhere to the common understanding by, among other things, making telephone calls to market makers who have violated the quoting convention or narrowed the inside spread; d. The companies here and other market makers have threatened to refuse, and refused, to deal with traders and firms that have violated the quoting convention; e.Absent a common understanding, it would not have been in the economic self-interest of the companies and other market makers to narrow their dealer spreads below 3/4s of a point as a condition of being able to adjust their bid and ask prices in odd-eighths, as a narrower dealer spread imposes a greater economic risk to market makers; f.Absent a common understanding, there are numerous instances in which it would have been in the economic self-interest of market makers freely competing with one another to maintain a dealer spread of 3/4s of a point or greater and yet have improved their bid or ask prices by 1/8 of a point, rather than by 1/4 of a point; g.Confronted by (1) widespread news reports of an academic study that indicated collusion in the NASDAQ market, and (2) a major and continuing investigation by the Antitrust Division of the Department of Justice, the companies here and other market makers have altered their quoting practices by using odd-eighth increments for bid and ask quotes in some stocks where such increments were previously avoided.
This abrupt change in behavior cannot be explained by any reduction in the above companies’ costs of doing business, nor by any change in market structure, trading strategy, or the fundamentals of the underlying stocks; and h. Market makers, including the companies here and others, frequently have used and continue to use an electronic trade system known as Instinet on which to buy and sell, at odd-eighth prices, the same NASDAQ stock that they have quoted and continue to quote only in even-eighth prices on NASDAQ.The fact that these companies have used and continue to enter orders to buy and sell NASDAQ stocks at prices quoted in odd-eighths on a proprietary trading system that is comparable to NASDAQ shows that the absence of odd-eighth quotes on NASDAQ is not the result of any fundamental attributes of those stocks and is evidence that the quoting convention has operated and continues to operate on NASDAQ to keep the inside spread in numerous NASDAQ stocks at 1/4 point or greater.MARKET IMPACT The purpose and effect of the potential quoting convention has been to raise, fix, and stabilize the inside spread on a substantial number of NASDAQ stocks at a minimum of 1/4 point. The quoting convention has potentially had the following effects, among others: 1. price competition among the companies in question in the purchase and sale of NASDAQ securities might have been restrained; 2.
nvestors who have purchased or sold NASDAQ securities might have been deprived of the benefits of free and open competition in the purchase and sale of NASDAQ securities; and 3. the inside spread on a substantial number of NASDAQ stocks has possibly been wider than it would have been in a competitive market, resulting in higher transaction costs for buying and selling NASDAQ stocks. APPENDIX A: List of Companies Involved in the Suit ALEX. BROWN & SONS INC. BEAR, STEARNS & CO.
, INC. CS FIRST BOSTON CORP.DEAN WITTER REYNOLDS, INC. DONALDSON, LUFKIN & JENRETTE SECURITIES CORP. FURMAN SELZ LLC GOLDMAN, SACHS & CO.
HAMBRECHT & QUIST LLC HERZOG, HEINE, GEDULD, INC. J. P. MORGAN SECURITIES, INC. LEHMAN BROTHERS, INC. MAYER & SCHWEITZER, INC.
MERRILL LYNCH, PIERCE, FENNER & SMITH, INC. MORGAN STANLEY & CO. , INC. NASH, WEISS & CO. OLDE DISCOUNT CORP. PAINEWEBBER INC.
PIPER JAFFRAY INC. PRUDENTIAL SECURITIES INC. SALOMON BROTHERS INC. SHERWOOD SECURITIES CORP. SMITH BARNEY INC. SPEAR, LEEDS & KELLOGG, LP UBS SECURITIES LLC