Question

What role do market makers play in the trading system? How do they profit from this role? How do the market makers compete with one another? How does the NASDAQ quoting convention work How do the market makers enforce the quoting convention? What elements are necessary to make a convention such as this work? Were these present in this case? What is the result of this type of quoting convention?

Answer 1

                                    Market makers refers to those members of the firm who are appointed by the stock exchange to inject liquidity and trade volume in to the stocks. In a trading system, they are responsible for continuously quoting prices at which they buy and sell for stocks. They are instrumental in providing liquidity and depth to the market.

                                    A market maker creates profit from the difference in the bid-ask spread ie; an amount by which the ask price exceeds the bid price for an asset in the market. It is generally the difference between the highest price that a buyer is willing to pay for an asset and the lowest rice that a seller is going to accept. They also makes profit by earning commission by providing liquidity to their client firms.

                                    The market makers compete with one another on the basis of the bid-spread. The more actively a market maker buys and sells, the more money that make out of the market. They are also compensated for the risk of holding an asset. Thus, risk taking strategies also decides the competitive trends of these market makers on how they generates profit out of the market. If a market maker is short of stocks, they may raise the bid value and vice versa thereby creating a level playing mechanism of competition.

                                    The NASDAQ is an electronic trading platform where the stocks are traded through automated computer programme networks instead of directly trading on the floor. It has three major components of trade ie; the Interface, which is a place where the broker dealers and market makers gains access to the system; a Matching engine, which is a computing system that connects the buyers and sellers when their prices match and Quote services which feeds the data of buying and selling price quotes provided by the NASDAQ. For a stock to be listed in NASDAQ, it has to follow certain requirements based on finances, liquidity and corporate governance. Based on the listing, the company shares will be displayed either in the Global select market, Global market or the Capital market and the generated trading system works.

                                    Under the quoting convention, stocks with a dealer spread of ¾ or greater are quoted in even-eights or quarters. The market makers uses the odd-eights in their bid and ask prices only if they first narrow their dealer spread in the stock to less than ¾ th of a point.

                                    The purpose of this potential trading convention has been to raise, fix and stabilise the inside spread on a substantial number of NASDAQ stock at a minimum of ¼ point. Apart from this, the following effects were also seen

· The insider spread in NASDAQ were found to be possibly wider than in other systems of competitive market resulting in higher transaction quotes for buying and selling of NASDAQ stocks.

· The price competition between the companies are found to be restrained.

                                          It has also to be analysed that the players of this market are deprived of the advantages of the open market system in purchase and sale of the securities.