Quoting Convention of NASDAQ Dealers Prompts a Justice Department Probe
Michael Baye and Patrick Scholten prepared this case study to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case is a condensed and slightly modified version of the public copy of the Complaint of Violation Statement, Civil Action No. 96 CIV 5313, dated July 17, 1996 in the United States of America v. Alex Brown & Sons Inc., et al.
The NASDAQ Stock Market, Inc. (NASDAQ) is the second largest securities market (measured by dollar value of trading) in the United States. NASDAQ market makers have offices in various states. Their market-making activities, and the violation alleged, affect investors located throughout the United States. During the time period covered, the companies in question have traded substantial numbers of shares of NASDAQ stock across state lines in a continuous and uninterrupted flow of interstate trade and commerce. The activities of each company as described here have been within the flow of, and have substantially affected, interstate commerce. POTENTIAL VIOLATION
The companies in question are major "market makers" in NASDAQ stocks. Market makers establish their NASDAQ quotes in a particular stock by simultaneously quoting prices at which they are willing to buy and sell particular NASDAQ stocks. The quote at which an individual market maker is willing to buy a particular stock is known as its "bid"; the quote at which it is willing to sell is known as its "ask." A market maker’s bid is always lower than its ask, and the difference between the two is known as its "dealer spread." There are at least two market makers in each NASDAQ stock. These market makers are purportedly independent and purportedly compete against other market makers, by, among other ways, quoting bid and ask prices on NASDAQ for particular stocks. The market maker’s bid- and ask-prices are organized and displayed on NASDAQ’s computerized quotation system. The market makers use this computer system to change and update their respective bid and ask prices and to continuously communicate their prices to the other market makers in particular stocks. At any given time, one or more than one market maker may have the best bid or ask price in a particular stock on NASDAQ. The highest bid price is known as the "inside bid"; the lowest ask price is known as the "inside ask." The difference between the "inside bid" (the highest price offered by any market maker to buy that stock) and the "inside ask" (the lowest price offered by any market maker to sell that same stock) is referred to as the "inside spread." Market makers earn money from the difference between the bid and ask, or the inside spread. Market makers therefore have an incentive to maintain wider inside spreads in NASDAQ stocks than would exist in a competitive market. The width of the inside spread in a stock has a direct impact on investors in NASDAQ stocks. The wider the inside spread, the greater the transaction costs for buying and selling NASDAQ stocks. Beginning at least as early as 1989, a common understanding might have arose among the companies listed in Appendix A companies and other NASDAQ market makers concerning, among other things, the manner in which bid and ask prices would be displayed on NASDAQ (the "quoting convention"). Under the quoting convention, stocks with a dealer spread of 3/4 point or greater are quoted in even-eighths (quarters). Under the quoting convention, market makers use odd-eighth fractions in their bid and ask prices only if they first narrow their dealer spread in the stock in question to less than 3/4 of a point. The listed companies and other market makers may have reached a common understanding to adhere to the quoting convention. This understanding is evidenced by, among other things, the following facts: a.
For a significant number of major...
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