Effects of market reform on trading costs of public investors: evidence from the London Stock Exchange

Naik, N and Yadav, P K (1999) Effects of market reform on trading costs of public investors: evidence from the London Stock Exchange. Working Paper. London Business School IFA Working Paper.

Abstract

In October 1997, the London Stock Exchange removed the obligation of dealers to quote firm twoway prices for FTSE 100 index stocks, and allowed the public to compete directly with dealers in these stocks through the submission of limit orders. This article examines the effects of these market reforms on trading costs of "public" investors, the targeted beneficiary of the reforms, and documents several interesting results. First, the duly signed average effective halfspread of public investors has decreased much more than the corresponding decrease in the absolute effective halfspread documented by Barclay et.al. (1998) for NASDAQ. This is because a subset of public investors trade through limit orders, and thereby earn the spread rather than pay it. Second, consistent with the change from obligatory to voluntary market making, there is a significant increase in the "positioning revenue" earned by dealers from a change in the price of a stock while they are carrying the stock in their inventory. As a result, the overall gain of public investors in terms of the realised halfspread is not significantly different from zero. Third, the crosssubsidisation across trade sizes has disappeared, leading to a significant decline in the average execution costs of small public trades and an increase for large pubic trades. Fourth, the market reforms have caused negative externalities for stocks not going through the new trading system. Finally, in the absence of the price stabilisation provided earlier by dealers, the inside halfspread has increased very sharply in the first hour of trading a finding which highlights the need for special opening procedures for electronic order books.