Market Makers: waiting for the UK Spreadgate

story of a system greedily out-of-control whose main concern was, and remains, maximizing profits at the expense of millions of unaware individual investors.

CAN IT HAPPEN HERE ????

Spreadgate

The upcoming settlement deadline of December 8th for the Nasdaq market-maker antitrust litigation suit has its beginnings in Jackson Hole, WY in 1991. It was here that Professors William G. Christie and Paul H. Schultz decided to work jointly on what they believed would be an innocuous microeconomic study of equity spreads.
Join us as we tell the story of the these two present-day Robin Hoods, who drew a clear mathematical correlation between Nasdaq stock spreads and market-maker collusion. We're grateful for their work and for the opportunity to tell their story of a system greedily out-of-control whose main concern was, and remains, maximizing profits at the expense of millions of unaware individual investors.

by a Wall Street Jovial staff reporter

JOVIAL HEADQUARTERS - The fascinating story that followed the union of these two college finance professors has a stark similarity to the events that unfolded when Bob Woodward and Carl Bernstein "stumbled" upon Watergate. It speaks volumes for the perennial search for truth and the constantly evolving and unique American ecopolitical landscape.

After downloading Nasdaq Level II Bridge data from November 15, 1991, a day in which the Dow Jones Industrial Average fell 4 1/2 %, its second biggest one-day percentage drop ever, and the Nasdaq dropped 4%, in order to study the competitiveness of market-makers during times of increased risk and volatility, Christie and Schultz "stumbled" upon what they thought might have been an erroneous reading. After sorting 35 stocks by 1/8 fraction spreads, what stood out to them was how infrequently the stocks were quoted in odd-eighth prices. In fact Apple Computer and Lotus Development had not been quoted with an odd-eighth price all day! As market-makers were updating the quotes, prices were ending up on all even-eighths.

Struck by the mathematical improbability of the results, they decided to study the 100 biggest Nasdaq stocks, on a stock-by-stock basis for the entire year. Again, the results showed a clear desire on the part of the market-makers to use even-eighth prices. Roughly 70% of the time even-eighth prices were displayed and around 30% of the time odd-eighth prices were used. In this way, the market-makers were able to keep spreads at least as wide as a quarter, 70% of the time. Most disturbing, however, was how long these disparate quotes were displayed. Even-eighth prices remained visible for an average of 23 minutes, while odd-eighth prices lasted a mere 7 seconds! Perturbed by the data, they rang the Toronto Stock Exchange to see what they thought. When they mentioned these were Nasdaq quotes, the person on the other end of the line said, "Nasdaq, that's a cartel."

Not wanting to jump to any conclusions right away, nor make any false accusations, they drew up their first paper in November, 1993, titled "Do Nasdaq Market-Makers Collude To Keep Wide Spreads?" They sent this paper to the economic publication Journal of Finance, the official publication of the American Financial Association, which accepted it but asked they remove the word "collude," as they felt it was too harsh. Christie and Schultz agreed, and retitled it "Why Do Nasdaq Market-Makers Avoid Odd-Eighth Quotes?" They presented the paper to a conference at UCLA in February, 1994. Gene Finn, the chief economist of Nasdaq was waiting at the conference to dispute the study. The professors had a relationship with Mr. Finn and were surprised at his unprovoked assault on their academic work.

A relative calm ensued after the conference until May, 1994, when Professor Schultz, while having lunch at Ohio State University, decided it might be good idea to publicize the study. On Tuesday, May 24, 1994, a PR bulletin hit all the news wires. Incredibly, only one request for more information was received! Scot J. Paltrow of the Los Angeles Times wanted a fax of the study. On May 26, 1994, Paltrow did a story on page D1, and, according to Professor Christie, "from that point on our lives changed." The entire day was spent running from phone to fax, as scores of previously uninterested parties were suddenly interested.

Perhaps the most incredible call, according to Professor Christie, was one from a lawyer received three hours after the paper hit the streets. Instinctually, Christie thought it was an NASD lawyer ordering them to retract their claims. He was shocked to find out it was a private lawyer, part of a Los Angeles, San Diego, and New York legal team assembled for a class-action suit against the market-makers! Apparently, these lawyers had been working to receive class-action status for quite some time, and on hearing about the Christie-Schultz report, felt they had what they needed to proceed.

Although everything that occurred since the article in the L.A. Times had rocked many involved with Nasdaq, nothing could prepare the investment world for what would follow the next day. Paltrow, tipped off about narrowing spreads from a Chicago stock exchange contact, notified Professor Christie, who did a study of five stocks, Amgen, Apple, Cisco, Intel and Microsoft, for May 27, 1994. What he discovered speaks for itself. Apparently, when unknown market-makers were apprised of the study, the percentage of odd-eighth quotes rocketed from the roughly 1% revealed by the study to 50% immediately! Professor Christie describes this study as the "smoking gun."

In order to more fully grasp the monumental ramifications of this study, we provide a link to a brief description and graph and ask that you see for yourself how much latitude these middlemen exercised when setting prices, and how when they realized someone was on to them, manipulated the frequency of odd-eighth quotes to conform with probability.

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