Nonlinear Dynamics in Nasdaq Dealer Quotes ∗

This paper considers nonlinear dynamics of quotes issued by Nasdaq dealers. We study the top two ECN’s (Island and Instinet) and the three most active market makers for a sample of twenty stocks traded at Nasdaq. We develop a model that extends the standard linear vector error correction model for price discovery in three different ways. First, quote adjustments are set relative to the inside quote, i.e. the best bid and ask in the market. Second, dealers react to the inside spread. Third, adjustments differ according to which dealer is currently at the inside. Adjustments are different if an Electronic Communication Network (ECN) is currently at the inside compared to an individual dealer. We attribute the differences to the asymmetric information among dealers. We study price discovery dynamics using generalised impulse responses