Competitiveness and price setting in dealer markets

The behavior of securities dealers has been closely scrutinized in the 1990s. Recent investigations of the National Association of Securities Dealers and the Nasdaq market by the U.S. Department of Justice and the Securities and Exchange Commission suggest that market makers colluded to fix prices and widen bid-ask spreads in attempts to increase dealers' profits at investors' expense. At a minimum, market makers appear to have adopted a quoting convention that can be viewed as anticompetitive behavior. ; This article explores the Nasdaq pricing controversy in light of economic theory and evidence of alleged collusion. Important findings in recent academic studies suggest that spreads may be large on Nasdaq because dealers had little incentive to compete using price and to narrow the spread. In addition to collusion, institutional features may produce spreads that are wider than observed in a purely competitive setting. ; The authors note that because dealers compete along nonprice dimensions, a judgment regarding the competitiveness of the Nasdaq market based solely on the width of the bid-ask spread is problematic. New rules approved by the SEC and recently implemented in the Nasdaq market should lead to narrower spreads and enhance price competitiveness.