Securities and Exchange Commission Historical Society

The Institution of Experience: Self-Regulatory Organizations in the Securities Industry, 1792-2010

Born Regulated

Market Makers and Odd Eighths

"Q. How important is The Nasdaq Stock Market compared to other equities markets?

A. Nasdaq initiated trading in February 1971, and has since experienced the greatest period of growth ever achieved by a stock market.

Over the last 7 years, Nasdaq's market share of dollar volume has virtually doubled. Daily transaction volume regularly tops 300 million shares...twice what is was in 1990. Nasdaq share volume over the first half of 1994 exceeded that of the New York Stock Exchange.

The Nasdaq Stock Market is a market that works well for both listed companies and investors alike."

- From "Knowing Nasdaq," enclosed in November 16, 1994 letter from Donald Johnson, Nasdaq Market Services to Martin Winter, Corporate Renaissance Group, Inc.

The creation of Nasdaq gave the NASD a dual status, both as a member regulator and as a market regulator. This dual status transformed the NASD more fundamentally than most contemporary observers understood.

The NASD, like the exchange SROs, was deeply affected by the l975 Securities Acts Amendments, particularly the provisions requiring SEC approval of all SRO rules before they became effective, and authorizing the SEC to initiate SRO rulemaking. Congress, frustrated that some brokers remained outside of the NASD, also provided for the establishment of the "SEC Only," or "SECO," program. The 1975 amendments formalized the NASD's status as the sole SRO for securities dealers by barring the creation of regional associations once anticipated by the architects of the Maloney Act.64

The SEC had once assumed that the NASD should control Nasdaq. By the 1990s, it appeared as if Nasdaq might be controlling the NASD. Individual traders operating on the Small Order Execution System, dubbed "SOES bandits," discovered that they could jump ahead of market makers who were slow—if only by seconds—to update prices. The NASD promulgated new rules to curb the practice, but market makers began to more diligently protect their spreads.65

How they protected spreads became apparent in the spring of 1994, when economists William Christie and Paul Schultz found that market makers avoided trading in "odd-eighths" and surmised that it was the result of collusion. At the time, trading was done in increments of an eighth of a dollar. By avoiding odd-eighths, market makers were effectively changing the increment to quarters of a dollar, thus ensuring a wider spread between bid and ask prices. What, by some accounts, may have begun as a matter of self-preservation in the face of the SOES Bandits had, by 1994, become a profitable convention, informally but effectively enforced.66

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(64.) 1975 NASD Annual Report, 14. The SECO program soon proved expensive and ineffective.   In 1983, at the SEC's insistence, Congress abolished it and required all broker-dealers (except those who traded exclusively on a stock exchange) to be members of a "national securities association," effectively making NASD membership mandatory; January 15, 1979 Letter from SEC Chairman Harold Williams to Gary Seevers, Commodity Futures Trading Commission, on registration of futures associations

(65.) Although the rise of odd-eighths trading followed closely upon the implementation of SOES, whether SOES bandits spurred Nasdaq market makers to employ it is hotly contested. See, for example, Allan W. Kleidon and Robert D. Willig, "Why do Christie and Schultz Infer Collusion from their Data?" 1995 Working Paper, Cornerstone Research, San Francisco, on the affirmative and Eugene Kandel and Leslie M. Marx, "Odd-Eighth Avoidance as a Defense Against SOES Bandits," Journal of Financial Economics 51 (January 1999), on the negative.

(66.) William G. Christie and Paul H. Schultz, "Why do Nasdaq Market Makers Avoid Odd-Eighth Quotes?" Journal of Finance 49 (December 1994).

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