Testing for Liquidity Gains in the Market Reaction to Nasdaq National Market System Phase-Ins

This study examines whether the market reaction to stock movements from the regular Nasdaq to the Nasdaq National Market System (NMS) is explained by changes in liquidity costs (i.e., spreads) and whether the relationship between pre-NMS spreads and market reaction to NMS transfers is consistent with realized liquidity cost changes. The study also tests whether the number of market makers affects the predictive power of the pre-NMS spreads on the price reaction to NMS phase-ins. Comprehensive tests are conducted on a sample of 672 stocks that were phased in from 1983 to 1991. This study finds new evidence that the market reaction to NMS phase-ins is directly related to the reductions in spreads and that the price reaction is positively related to the potential for liquidity gains. The pre-NMS number of market makers does not impact adversely the pre-NMS spread and market reaction relationship.