Preferencing, Internalization, Best Execution and Dealer Profits

Transparency matters: Price formation in the presence of order preferencing

“…For some levels of her inventory, she matches the best price posted by her opponent, which may be lower than her cutoff price. This result is consistent with the empirical evidence of Hansch, Naik, and Viswanathan (1999), who find that preferenced dealers on the London Stock Exchange (LSE) make zero profits over all trades. Note that (i) losses are not enough to outweigh the ex ante preference of dealer 2 for the opaque market in some cases; (ii) losses could even be bigger if we now assume that dealer 1 cannot observe whether a preferenced order flow is received or not by dealer 2, since the best price to match would be even more competitive.…”

“…Empirical evidence on whether these practices are deleterious for market competition is mixed at best. On the one hand, Klock and McCormick (2002) find that, even under preferencing arrangements, NASDAQ dealers still have incentives to be at the inside, just as the London Stock Exchange dealers (Hansch, Naik, and Viswanathan, 1999), or as specialists in NYSE-listed stocks (Bessembinder, 2003). On the other hand, Chung, Chuwonganant, and McCormick (2004) show that preferencing discourages quote competition and yields to wider spreads.…”

Should securities markets be transparent?

“…Initial inventory I i0 is not observed, and consistent with Hansch et al (1999), we set this value to zero. Only stocks that involve specialist participation during both periods are included.…”

Local market makers, liquidity and market quality

“…Kandel and Marx (1999) propose a model with both quotebased competition and payment for order flows and provide results consistent with empirical evidence. Refer to Huang and Stoll (1996), Dutta and Madhavan (1997), Bloomfield andO'Hara (1998), Hansch, Naik andViswanathan (1999), and Chung, Chuwonganant, and McCormick (2004) for the impact of internalization and payment for order flow on bid-ask spread. 7 See also Lipson (2003).…”