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Economists Prevent Collusion

William G. Christie and Paul H. Schultz, two assistant professors of finance, were studying data on stock trades through the National Association of Securities Dealers Automated Quotation (Nasdaq) system, when they noticed some activity that struck them as odd. This odd behavior, they thought, could only be explained by collusion on the part of stock dealers—either explicit or tacit.

The Nasdaq market is used to buy and sell stocks. Nasdaq dealers or "market makers" communicate directly with each other using computers or phones. Market makers post the prices at which they are willing to buy (the bid price) or sell (the ask price) stocks. If you place an order to buy or sell a stock, the order goes to the dealer offering the best price. The difference between the lowest ask price and the highest bid price is called the inside spread, which compensates the market makers for their services.

On the Nasdaq market, bid or ask quotes must be multiples of an eighth of a dollar if the bid price exceeds $10. As a result, bid or ask quotes end in either even-eighths (0, 2/8, 4/8, 6/8) or odd-eighths (1/8, 3/8, 5/8, 7/8). Thus, the narrowest inside spread is one-eighth. For example, if the bid price is $25.50 and the ask price is $25.625, the spread is one-eighth of a dollar, or 12.5¢ per share. Christie and Schultz expected, if the market was competitive, that all fractions would be seen with roughly equal frequencies—as is the case on the New York Stock Exchange. To their complete surprise, they found virtually no inside spreads on Apple Computer stock as small as one-eighth. Indeed, virtually all bids were in even eighths (which ensures that no one-eighth spreads will occur).

When they looked at the 100 most actively traded stocks, they found that odd-eighth quotes were extremely rare for 70 of them, including such highly visible and actively traded stocks as Intel, Amgen, Microsoft, and Cisco Systems. Thus, Christie and Shultz concluded that the market makers had an understanding not to use odd-eighth quotes on these 70 stocks, a practice that ensured that their inside spread would not fall below two-eighths, 25¢, per trade.

How could 60 independent market markers ensure that no one deviated from this policy? Detecting odd-eighth bids is easy because the market maker who posts such a bid is identified on everyone's computer screen.

When Christie and Schultz's academic paper on their research was accepted for publication, they issued a press release on May 24, 1994, describing their results. Only the Los Angeles Times called them the next day to discuss the story. When the Times ran the story on May 26, however, Christie and Schultz were inundated with calls from reporters and lawyers. A series of class-action antitrust lawsuits were filed. Those suits claimed that the antitrust laws were violated and asked that damages from overcharges be paid to the class or group of individuals who bought and sold stocks. Soon thereafter, the Justice Department started collecting information to see if it should sue.

By June 1, only days after the Los Angeles Times ran the story, virtually all market makers for the top ten stocks were using both odd- and even-eighth quotes. The lone holdouts were the market makers for Intel Corporation stock, who continued to use only even-eighth quotes. After the Los Angeles Times' October 19, 1994, report that the Justice Department was launching an investigation, even these persistent dealers started using odd-eighth quotes.

By exposing this practice, Christie and Shultz believe they've saved Nasdaq customers a bundle. After market makers started using odd-eighth quotes, inside spreads fell roughly in half, from an average of about 30¢ to about 15¢ per trade.

In 1997, 30 brokerage firms agreed to pay about $900 million to end a civil suit. Lawyers for the plaintiffs said it was the biggest settlement ever in a price-fixing lawsuit. This payment raises the amount paid by brokerage firms to more than $1 billion since 1994, when the suit was initially brought. The defendants did not acknowledge wrongdoing.

SOURCES: Barboza, David, "30 Firms to Pay $900 Million in Investor Suit," New York Times, December 25, 1997:A1, C6; Christie, William G., and Paul H. Schultz, "Why Do Nasdaq Market Makers Avoid Odd-Eighth Quotes?" Journal of Finance, 49(5), December 1994:1813-40; Christie, William G., and Paul H. Schultz, "Did Nasdaq Market Makers Implicitly Collude?" Journal of Economic Perspectives, 9(3), Summer 1995:199-208.

© 2003 Jeffrey M. Perloff. Reprinted by permission.





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