DEALER MARKET-STRUCTURE, OUTSIDE COMPETITION, AND THE BID-ASK SPREAD

We investigate the linkages between the number of dealers making marke ts in a security, the extent of outside (or nondealer) competition, an d the market bid-ask spread for NASDAQ NMS stocks. The investigation i s guided by a model that emphasizes dealers' interactions as their inv entories change, and predicts that the extent of outside competition l imits the bid-ask spread and the number of dealers. We hypothesize tha t the extent of outside market making capital in a stock is related to that stock's institutional holdings. Evidence shows that the extent o f institutional holdings relative to trading volume proxies for outsid e competition, For stocks with little outside competition, the spread is large even though the number of dealers is also larger than for com parable stocks. The component of the spread related to outside market making capital is economically significant (about 1/2 to 1 percent of price). The composition of volume as to trade size and trade frequency , which is related to the level of institutional holdings, also influe nces the spread.