Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE

Execution costs, as measured by the quoted spread, the effective spread (which accounts for trades inside the quotes), the realized spread (which measures revenues of suppliers of immediacy), the Roll(1984) implied spread, and the post-trade variability, are twice as large for a sample of NASDAQ stocks as they are for a matched sample of NYSE stocks. The difference is not due to differences in adverse information, in market depth, or in the frequency of even-eighth quotes. Partial explanations are provided by differences in the treatment of limit orders and commissions in the two markets. We conclude that important explanations are the internalization and preferencing of order flow and the presence of alternative interdealer trading systems, factors that limit dealers' incentives to narrow spreads on NASDAQ.