Electronic communication networks, market makers, and the components of the bid-ask spread

Purpose – The purpose of this paper is to investigate how quotes originating via electronic communication networks (ECN)s affect trading costs. Design/methodology/approach – In order to investigate the relations between trading costs and quotation venue, the bid-ask spread is decomposed into its theoretical cost components associated with adverse selection, inventory handling, and order processing. Findings – Stoll's adverse selection costs of ECN-originated quotes relate positively to effective spreads, while Lin et al.'s adverse selection costs relate negatively to effective spreads. Originality/value – The paper shows how trading costs relate to trading venue choice by decomposing the bid-ask spread.