Third Market Broker‐Dealers: Cost Competitors or Cream Skimmers?

This article compares the bid‐ask spread for New York Stock Exchange (NYSE)‐listed securities before and after a major third market broker‐dealer, Bernard L. Madoff Investment Securities (Madoff), begins to selectively purchase and execute orders in those securities. Tests reveal the quoted bid‐ask spread tightens when Madoff enters the market. Furthermore, trading costs as measured by the difference between the transaction price and the midpoint of the contemporaneous bid‐ask spread do not increase. Together, these results suggest that the adverse selection problem associated with allowing agents to selectively execute orders in exchange‐listed securities may be economically insignificant.