Table of Contents
In the 1990s, many NASDAQ quotes started to come under intense scrutiny over the potential of collusion after professors William G. Christie and Paul H. Schultz published the study “Why did NASDAQ Market Makers Avoid Odd-Eighth Quotes?”
Christie and Schultz found that many NASDAQ stocks were mainly quoted in quarters, not in odd-eighths (i.e. quotes that end in one, three, five, or seven eighths). AMEX and NYSE, on the other hand, generally quoted in eighths. Christie and Schultz argued that “individual market makers implicitly agree to maintain spreads of at least $0.25 by not posting quotes on odd eighths.”
Spread, as it pertains to the stock market, refers to the difference between the lowest ask price and the highest bid price. For example, let’s say the lowest ask price of a share of X stock is $10 and the highest bid price is $9.00. The spread for X stock would be $1.00.
While the difference between quarters and eighths seems negligible, market makers (MMs) were able to execute over a thousand trades per day. Multiply that 12.5 cent differential (25 cents – 12.5 cents) by a thousand, and ~$125 extra in profits can be made just in one day. Over time as well as across NASDAQ market makers, you can just imagine how much extra unethical profits were there to be made.
Key Questions to Consider
- Does the research paper, as well as other evidence, provide strong proof that NASDAQ investors and/or their traders made massive wealth by skimming money off of artificially wide spreads?
- If this price NASDAQ quote fixing scheme is true, do you consider it an instance contributing to a rigged economy, theft against investors?
- Was the legal action taken commensurate to the crime? Should there have been a criminal trial?
Examining the Study on the NASDAQ Stock Market
Christie and Schultz made serious claims against the NASDAQ market makers of the 90s, so it seems only right we dedicate some time to examining the professors’ evidence and conclusions.
Does the research paper, as well as other evidence, provide strong proof that NASDAQ investors and/or their traders made massive wealth by skimming money off of artificially wide spreads?
“The NASDAQ multiple dealer market is designed to produce narrow bid-ask spreads through the competition for order flow among individual dealers. However, we find that odd-eighth quotes are virtually nonexistent for 70 of 100 actively traded NASDAQ securities, including Apple Computer and Lotus Development.
In a free market, MMs should be competing against each other to sell stocks. Wide spreads benefit the MM, but they aren’t necessarily possible to achieve when other market actors are competing against you. One would expect a competitive market to compel MMs to lower the asking price in order to attract investors.
However, during the period of study, Christie and Schultz found “70 out of 100 actively traded NASDAQ securities” did not have odd-eighth quotes. MMs might have been competitive for the most part, but that’s only under the alleged collusion ensuring they all got a bit more on each trade.
Explaining the Scarcity of Odd-Eighth NASDAQ Quotes
“The lack of odd-eighth quotes cannot be explained by the negotiation hypothesis of Harris (1991), trading activity, or other variables thought to impact spreads. This result implies that the inside spread for a large number of NASDAQ stocks is at least $0.25 and raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.”
Christie and Schultz claim, in other words, that the lack of odd-eighth NASDAQ quotes cannot be explained by natural free market forces. Such a thing could not have possibly happened, unless market actors had agreed to rig prices. No other reasonable explanation exists, according to the professors.
A 2017 Forbes article reports, “For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed…Buying back company stock can inflate a company’s share price and boost its earnings per share — metrics that often guide lucrative executive bonuses.” See what the ZT community has uncovered about stock buybacks…
NASDAQ vs. NYSE and AMEX
“The lack of one-eighth spreads can be traced to an absence of either inside bid or inside ask quotes ending in odd-eighths…In contrast, a sample of 100 New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) firms of similar price and market value to our NASDAQ sample consistently use the full spectrum of eighths.”
Using eighths does not necessarily mean that, in practice, the NASDAQ prices are markedly higher vs. the NYSE or AMEX’s prices. Data, however, suggests this is the case.
Christie, along with a different academic in Robert D. Huang, published a study tracking the prices of stocks that moved from NASDAQ to either the NYSE or the AMEX during 1990. They found that their sample quoted spreads declined by an average of $0.31 per share when stocks moved to the AMEX and by $0.06 per share to the NYSE.
Professor Michael J. Barclay published a research paper in which he tracked the prices of 472 securities that were listed on Nasdaq and moved to the NYSE or Amex. He concluded from his analysis that “…bid-ask spreads fall when securities move from Nasdaq to the NYSE or Amex…and more importantly, the large difference in effective spreads between securities for which the market makers avoid odd eighths and those for which market makers use both odd and even eighths is nearly eliminated when the same securities are traded on the NYSE or Amex.”
Legal Actions Triggered by the Study
The case laid out in Christie and Schultz’s study proved compelling, as it caught the attention of the Department of Justice (DoJ) and the Securities and Exchange Commission (SEC).
The agencies conducted an investigation into the NASDAQ stock market, and about a year after the study had been published, numerous investment firms were dealing with charges from the DoJ and civil suits from over a million disgruntled investors.
If the price NASDAQ quote fixing scheme is true, do you consider it an instance contributing to a rigged economy, theft against investors?
According to a 1996 DoJ press release, “The Department’s Antitrust Division filed a civil antitrust suit charging 24 major NASDAQ market makers who buy and sell stocks to the investing public with inflating the quote ‘inside spread’ in certain NASDAQ stocks, resulting in investors having to pay more to buy or sell stocks than they would have in a competitive market…Transaction costs were raised through a long-standing ‘quoting convention’ followed by traders and enforced industry-wide for many years…”
The press release lists all 24 investment firms included in the civil antitrust suit:
Alex. Brown & Sons Inc.
Bear Stearns & Co. Inc.
CS First Boston Corp.
Dean Witter Reynolds Inc.
Donaldson, Lufkin & Jenrette Securities Corp.
Furman Selz LLC
Goldman, Sachs & Co.
Hambrecht & Quist LLC
Herzog, Heine, Geduld Inc.
J.P. Morgan Securities Inc.
Lehman Brothers Inc.
Mayer & Schweitzer Inc.
Merrill, Lynch, Pierce, Fenner & Smith Inc.
Morgan Stanley & Co. Inc.
Nash, Weiss & Co.
OLDE Discount Corp.
Piper Jaffray Inc.
Prudential Securities Inc.
Saloman Brothers Inc.
Sherwood Securities Corp.
Smith Barney Inc.
Spear, Leeds & Kellogg LP (Troster Singer)
UBS Securities LLC
“For instance, if an investor asked to buy shares of a company at $20.125, a broker might return with shares bought at $20.25, saying the shares were unavailable at the lower price. The broker would then pocket the difference. In deals where hundreds of thousands of shares were traded, that spread of 12.5 cents could add up to a large sum of money.”
Total reparations for all the NASDAQ one-eighth spread cases exceeded $1 billion, according to the NYT.
INVESTIGATIONS INTO THE FINANCE SECTOR
How much profits were made?
The lawsuits did not disclose the estimated amount lost by investors, but it would not be unreasonable to think that the sum was considerable.
Vanderbilt University conducted an interview with their esteemed professor Christie.
He reflects on the study that triggered the Doj investigations: “…some of the most active NASDAQ stock was they avoided half of the price fractions, so when you quote in 12.5 cents per dollar and you eliminate all of the odd eighth quotes, you’re eliminating the one, three, five, seven eighth. What you’re left with are the even eighth quotes and those have the difference of 25 cents, which is double the spread or double the profit the market maker should have been making. So what that did was that inflated the trading costs for the investors to the benefit of the market makers.”
Take that doubled spread and multiply for every single trade that involved the quarter rate. We could be talking about millions in unethical profits/ripped off funds divided among investors. The $900 million settlement, at least, suggests the estimated losses were significant.
Was it Enough?
Was the legal action taken commensurate to the crime? Should there have been a criminal trial?
Considering the evidence offered by multiple studies, not just Christie and Schultz’s, along with the resolutions of multiple civil lawsuits, did the punishment match the crime?
Corporate crime and white collar crime often result in hefty fines, but no jail time. The punishment starkly contrasts with the penalties for street crimes. We are talking about an alleged case where million-plus investors lost money. The impact, if the crime truly occurred, is nationwide.
Do you think the alleged bad actors involved in offering odd-eighth NASDAQ quotes should have gone through a criminal trial?
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