Cold Case File? Inventory Risk and Information Sharing during the pre‐1997 NASDAQ

Date01 September 2017
Published date01 September 2017
Cold Case File? Inventory Risk
and Information Sharing during the
pre-1997 NASDAQ
Laurence Lescourret
ESSEC Business School, 3 avenue Bernard Hirsch, 95021 Cergy-Pontoise, France
This paper shows that dealers in Over-The-Counter (OTC) ma rkets might
choose to share information about tr ansient price pressures. Using data from the
pre-1997 NASDAQ preopenin g, I nd that the frequency and magn itude of
non-positive spreads (the i nformation-sharing vehic le) initiated by wholesaler s
(specialised market-make rs with a high exposure to in ventory risk) are strongly
related to opening price revers als and daily trading imbalan ces. This activity is
more likely to occur on days o f large liquidity shocks, a nd it is not observed for
other dealers. Overall, the ob ligation to absorb price press ure at a yet unknown
opening price might induce de alers to communicate the direc tion in which
the opening price should move. The ndings contain lessons for the design of
Keywords: OTC markets, preopen, NASDAQ, information sharing, price reversals
JEL classification: G12,G14,D82
A NASDAQ trader, knowing he has a large volume of buy orders to ll [...] will enter
a bid that is the same as or higher than the offer to signal his need to get the price moving
and his orders lled. (Crossed and Locked Markets Create a Problem for NASDAQ,
Wall Street Journal, 18 March 1999)
This paper greatly benefited from comments and suggestions of John Doukas (the Editor),
three anonymous referees, Thierry Foucault, Jos
e Miguel Gaspar, Sophie Moinas and
participants at ESSEC Business School, and CORE Econometric seminars. Laurence is
research fellow at CREST. Laurence gratefully acknowledges Imperial College for a
visiting position in 2011 and the French National Research Agency (ANR) for its financial
support (ANR-10-JCJC-1810-01). An earlier version of this paper circulated under the title
Why is there heterogeneity among dealersbehavior during the NASDAQ preopening
session?The usual disclaimer applies.
European Financial Management, Vol. 23, No. 4, 2017, 761806
doi: 10.1111/eufm.12119
© 2017 John Wiley & Sons, Ltd.
A global probe into foreign-exchange markets has unearthed evidence that traders
frequently colluded to try to manipulate currencies [...] A trader at one bank would
accumulate all of his institutionsbuyorders in a specic currency. Then he would share
this information with his competitors and exchange information about their overall
positions. (Forex Traders Said To Have Colluded In Effort To Prot,Wall Street Journal,
19 December 2013)
1. Introduction
The practice of information sharing among dealers in Over-The-Counter (OTC) markets
has come to the forefront of regulatory and academic debate, after recent investigations
showed that OTC intermediaries share information about clientsorders.
noticeable characteristics are common to all these cases of information sharing. First,
they occur in non-anonymous dealer markets in which a few big intermediariesquoting
strategies (e.g., large banks) might inuence other players. Second, information is shared
during a short period preceding the determination of a benchmarkprice used for
executing clientsorders. Third, dealers share information which concerns temporary
order imbalances unrelated to asset fundamentals. Such non-fundamental or inventory
information (Cao et al., 2006) might have common-value components related to the
market trading environment (for instance, a liquidity shock due to a distressed trader) and
specic private-value components related to participants (e.g., inventory adjustments,
speed of trading, etc.).
Inventory information is valuable during trading hours,
especially in dealer markets operated by risk-averse intermediaries in which inventory
concerns are more exacerbated, like most OTC markets such as the Foreign Exchange
(FX) market, or the NASDAQ before 1997 when it was a pure quote-driven market.
This paper examines the impact of non-fundamental information sharing among
dealers using the NASDAQ preopening before 1997. In an important contribution, Cao
et al. (2000) nd that NASDAQ dealers used non-binding preopening quotes to signal
information related to fundamentals to ease price discovery at the open. My paper aims at
complementing their ndings by focusing on non-fundamental information. I argue
that dealers nd it desirable to signal information not necessarily about fundamentals, but
also about order ow imbalances or inventory shocks. I therefore ask the following
Do NASDAQ dealers use preopening quotes to share transient non-fundamental
information with the market?
Are opening trading pressures related to dealerspreopening quoting behaviour?
Examples include the rigging of the London Interbank Offered Rate (LIBOR), the allegation
of rigging at auctions of US Government debt, or the allegation of manipulation of Foreign
Exchange benchmarks to which the opening quote refers.
This information is also designated as non-payoff relevant(Barclay et al., 2006).
The order-handling rule implemented in 1997 enforced competition between dealers and
anonymous limit order traders by requiring the inclusion of limit orders posted on Electronic
Communication Networks (ECNs) in the calculation of the best market prices (National Best
Bid and Offer). Proliferation of ECNs followed signicantly altering the way NASDAQ
operated, and changing the competitive behaviours of dealers.
© 2017 John Wiley & Sons, Ltd.
762 Laurence Lescourret
I use this setting for several reasons. First, the NASDAQ in 1996 operated as a pure
non-anonymous dealer market, in which transient order ow imbalances impacted risk-
averse intermediaries holding sub-optimal positions. Several studies show that inventory
control plays a central role in the price formation of dealer markets.
Second, at that time,
NASDAQ dealers had the obligation to execute incoming orders at the best price, either
because they posted this best price, or because they received orders from afliated
brokers which they had guaranteed to execute (a practice referred to as preferencing
The opening was especially risky due to overnight information
accumulation and the required guarantee to ll orders at the opening printprice (the
rst reported trade). Trading during preopening hours was in practice not feasible due to
prohibitive transaction costs and volatility. Quoted and effective bid-ask spreads were
more than four times larger in the preopen than during the trading day, mostly due to
adverse selection costs higher than at any other periods of the day (Barclay and
Hendershott, 2004).
Building a position minimising inventory exposure at the open
through trading could only be achieved at an high cost. Third, to our knowledge, there
exists no other dataset on quote-driven markets in which dealerscommunicating
behaviour is clearly identied. Signaling preopening quotes arose partly because, during
our time period, NASDAQ dealers were unable to use telephone calls to solicit trades due
to governmental investigations of alleged collusion.
Using this unique dataset is thus
very relevant for analysing dealersinformation-sharing behaviour.
The empirical approach consists of investigating the impact of dealersnon-binding
quotes (the information-sharing vehicle) on measures of trading pressure at the open
such as price reversals or trading imbalances. In particular, I focus on the behaviour of
wholesalers, a group of very large dealers specialised mainly in market-making during
the period in question. Wholesalers dont provide sell-side research coverage from which
they could obtain fundamental information (e.g., Schultz, 2003; Madureira and
Underwood, 2008). They mainly handle retail order ow during the period of the
analysis (Grifnet al., 2003), which consists of mostly uninformed trades susceptible to
waves of investor sentiment (DeLong et al., 1990). Moreover, wholesalers do not
possess brokerage arms and therefore have to pay outside brokers to get access to order
See, among others, Hansch et al. (1998) for London Stock Exchange data; Lyons (1995) or
Bjønnes and Rime (2005) for foreign exchange markets, or Friewald and Nagler (2015) for
US corporate data. For NYSE specialist data, see, for example, Madhavan and Smidt (1993),
Comerton-Forde et al. (2010) or Hendershott and Menkveld (2014).
Preferencing and one of its various forms, internalisation, refers to practices that allow
brokers and institutional investors to have prearranged transactions with a preferenced dealer
(a quote-matcher), avoiding search costs for the best price. Launched by one of the NASDAQ
wholesalers Madoff this practice has been highly controversial but still widespread in the
US equity and option markets.
Using 112 trading days in 2000, Barclay and Hendershott (2004) nd that the cost of the 50
most active NASDAQ stock during the preopen was 27.7 cents, compared to 7.8 cents during
the trading day. Due to a coarser tick size during my sample period, it probably implies that
transaction costs were even higher in 1996.
The Department of Justice and the SEC had started formal investigations against NASDAQ
dealers in 1995 following the avoidance of odd-eightquotes shown by Christie and Schultz
(1994) that suggested tacit collusion.
© 2017 John Wiley & Sons, Ltd.
Inventory Risk and Information Sharing during the pre-1997 NASDAQ 763

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