An investor who wishes to purchase or sell shares engages a broker who tries to locate the dealer offering the best deal on the security. This is in contrast to exchange trading, where all buy or sell orders are negotiated through the specialist, who arranges for the best bids to get the trade. In the OTC market, brokers must search the offers of dealers directly to find the best trading opportunity. In this sense, Nasdaq is a price quotation system, not a trading system.
While bid and ask prices can be obtained from the Nasdaq computer network, the actual trade still requires direct negotiation (often over the phone) between the broker and the dealer in the security. However, in the wake of the stock market crash of 1987, Nasdaq instituted a Small Order Execution System (SOES), which is in effect a trading system. Under SOES, market makers in a security who post bid or ask prices on the Nasdaq network may be contacted over the network by other traders and are required to trade at the prices they currently quote. Dealers must accept SOES orders at their posted prices up to a limit which may be 1,000 shares, but usually is smaller, depending on factors such as trading volume in the stock.
Because the Nasdaq system does not use a specialist, OTC trades do not require a centralized trading floor as do exchange-listed stocks. Dealers can be located anywhere they can communicate effectively with other buyers and sellers.
One disadvantage of the decentralized dealer market is that the investing public is vulnerable to trading through, which refers to the possibility that dealers can trade with the public at their quoted bid or asked prices even if other customers have offered to trade at better prices.
A dealer who posts $20 bid and $20.15 asked prices for a stock may continue to fill market buy orders at the ask price and fill market sell orders at the bid price—even if there are limit orders by public customers “inside the spread,” for example, limit orders to buy at $20.05 or limit orders to sell at $20.10. This practice harms the investor whose limit order is not filled (is “traded through”) as well as the investor whose market buy or sell order is not filled at the best available price.
Trading through on Nasdaq sometimes results from imperfect coordination among dealers. A limit order placed with one broker may not be seen by brokers for other traders because computer systems are not linked and only the broker’s own bid and asked prices are posted on the Nasdaq system. In contrast, trading through is strictly forbidden on the NYSE or Amex, where “price priority” requires that the specialist fill the best-priced order first. Moreover, because all traders in an exchange market must trade through the specialist, the exchange provides true price discovery, meaning that market prices reflect the prices at which all participants at that moment are willing to trade. This is the advantage of a centralized auction market.
In October 1994, the Justice Department announced an investigation of the Nasdaq Stock Market regarding possible collusion among market makers to maintain spreads at artificially high levels. In 1996, the Justice Department settled with the Nasdaq dealers. The dealers agreed to refrain from pressuring any other market maker to maintain wide spreads and from refusing to deal with other traders who try to undercut an existing spread.
Also in 1996, the SEC settled with the National Association of Securities Dealers (NASD) as well as with the Nasdaq stock market. The settlement called for NASD to take steps to prohibit market makers from colluding on spreads. In addition, the SEC mandated the following three rules on Nasdaq dealers:
- Publicly display all limit orders. Limit orders from all investors that exceed 100 shares must now be displayed. Therefore, the quoted bid or ask price for a stock must now be the best price quoted by any investor, not simply the best dealer quote. This shrinks the effective spread on the stock.
- Make best dealer quotes public. Nasdaq dealers must now disclose whether they have posted better quotes in private trading systems or ECNs such as Instinet than they are quoting in the Nasdaq market.
- Reveal the size of best customer limit orders. For example, if a dealer quotes an offer to buy 1,000 shares of stock at a quoted bid price and a customer places a limit buy order for 500 shares at the same price, the dealer must advertise the bid price as good for 1,500 shares.
Read More: TRADING ON THE OTC MARKET
