Economics Update (October-December 1998)

Theory and Evidence Shed Light
On Nasdaq Controversy

D id securities dealers collude to fix prices and widen bid-ask spreads? This question was the focus of a recent investigation of the National Association of Securities Dealers and the Nasdaq market by the Securities and Exchange Commission and the U.S. Department of Justice.

While academics have amassed substantial evidence relating to the Nasdaq scandal, they have not reached a consensus concerning whether dealers colluded. Lucy F. Ackert, a senior economist at the Atlanta Fed, and Bryan K. Church, an associate professor at the Georgia Institute of Technology, explore the Nasdaq pricing controversy in light of economic theory and evidence of alleged collusion in an article in the Atlanta Fed's Economic Review (Third Quarter 1998).

Ackert and Church's article provides a framework for understanding the significance of the Nasdaq controversy. The authors examine the role securities markets play in promoting a stable economy and review the two organizational structures commonly adopted — auction and dealer markets. They also consider the sources and economic consequences of divergence in spreads, elaborate on what constitutes collusive behavior, and summarize the case against Nasdaq.

Spreads may be large on Nasdaq, Ackert and Church find, because dealers had little incentive to compete using price and to narrow the spread. In addition, institutional features such as preferencing may limit competition for order flow, the effect of which is to produce spreads that are wider than those observed in a purely competitive setting.

By removing institutional obstacles, policymakers encouraged price competition. Ackert and Church note that if orders are exposed to the entire market, dealers have greater incentive to improve inside price quotes and may compete less on nonprice dimensions and offer fewer services to their clients.

Stern warnings and scrutiny from regulators and investigators are likely to dampen dealers' incentives to engage in collusive arrangements, whether explicit or implicit. Recent changes in the market, Ackert and Church conclude, should lead to narrower spreads and improved market efficiency.

Return to Index