"The NYSE and AMEX are order-driven continuous auction markets, the linchpins of which are market makers called specialists. Specialists facilitate continuous trading by posting quotes for their own account or by reflecting the best quotes on their limit order book, which represent a centralized depository for limit orders to buy or sell stocks at specified prices or better. Limit orders play a major role in providing immediacy and liquidity on the NYSE/AMEX as seen by the fact that over 80% (88%) of the volume on NYSE (AMEX) arise from trades in which the specialists do not participate for their own account. In contrast to the NYSE/AMEX markets, the NASDAQ market is based on a competing dealer system in which each dealer continually posts firm bid and ask quotes on an electronic screen. Further, there is no central limit order book on NASDAQ, although limit orders may be left with individual broker-dealers. However, unlike the NYSE/AMEX, limit orders on NASDAQ do not drive the posted quotes since dealers are not required to consider limit orders in setting their quotes. Also, dealer competition is diminished by rules allowing directed order flow to less competitive dealers who agree to meet the best quotes.
Other important institutional differences exist between the NYSE/AMEX and NASDAQ exchange systems, which may affect the speed of price adjustment. Specialists on the NYSE/AMEX are not allowed to trade ahead of limit orders at the same prices and their quotes often reflect the limit order book rather than commitments by individual specialists. This reduces specialists’ incentives to immediately adjust quotes to new information, since execution of the posted quotes often has no impact on their inventory positions or wealth. Furthermore, limit orders can not be updated instantaneously, nor can they be conditioned on public information such as the stock’s last transaction price. As a result, limit prices are temporarily stale immediately after public announcements. This slow updating of limit orders can delay revisions in the best bid and ask quotes. Moreover, hitting stale limit orders following announcements with negative price impacts may not be easy for traders in the NYSE/AMEX markets due to the uptick rule, which prevent traders from short selling on a down tick or a zero tick following a down tick. More generally, arbitrage of stale limit orders is discouraged by bid-ask spreads and the price impacts of market orders, which together can exceed the potential profits from arbitrage when information effects are modest and/or secondary markets are not highly liquid.
NASDAQ dealers must post firm bid and ask quotes for at least 1000 shares and can not rely on the limit orders of other investors. Neither dealers nor investors are constrained from short selling by an uptick rule. Thus, if dealers do not immediately adjust their quotes to new information, they are vulnerable to other traders selectively hitting their stale quotes, causing them trading losses. Hence, NASDAQ dealers have strong financial incentives to revise their quotes immediately following public announcements, even in the absence of trades. These arguments suggest NASDAQ quotes should" »»» Click Here For More
