Review of Quantitative Finance and Accounting, 23: 149–166, 2004
2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Can Island Provide Liquidity and Price Discovery
in the Dark?
AND JAMES C. HACKARD
Department of Finance, College of Business, University of Texas at San Antonio, San Antonio, TX 78207,
USA, Tel.: 210-458-5314
Abstract. On September 23, 2002, facing a regulatory mandate issued by the Securities and Exchange Com-
mission, Island teminated the position of the Nasdaq 100 Index Tracking Stock (QQQ) on its book. While the
market volume remained almost the same, Island’s market share in the QQQ fell signiﬁcantly. However, Island
still dominates other trading centers in the price discovery process and volatility spillovers. The spreads on most
trading centers became narrower after Island removed its quotes from the public view. The overall results suggest
that the decrease in market transparency does not compromise market liquidity. Informed traders who provide
price discovery in the QQQ are willing to sacriﬁce potential price improvements for the fast speed and reliable
execution that Island offers, and are able to trade in the absence of displayed quotes.
Keywords: QQQ, liquidity, price discovery, trade-through rule, market transparency
JEL Classiﬁcation: G13, G20, C32
This paper examines liquidity, price discovery, and trading costs for the Nasdaq 100 Index
Tracking Stock (QQQ) traded on the Island Electronic Communications Network (Island
ECN) in light of changes in the application of a Securities and Exchange Commission (SEC)
rule. The rule, effective September 23, 2002, requires that Island either represent its top
of book in the QQQ and four other heavily traded Exchange-Traded Funds (ETFs) in the
National Consolidated Quote System (NCQS) of the Intermarket Trading System (ITS), or
not post the quotes at all.
Island chose the latter and trades the ETFs in a blind matching
The QQQ is the most actively traded security in the world, with an average daily volume
of over 90.0 million shares for the period surrounding September 23, 2002. Since the week
of October 15–19, 2001, when it surpassed the American Stock Exchange (Amex), Island
has occupied the position as the dominant trader of QQQs, executing as much as 40% of
the traded volume of that popular ETF during the ﬁrst two-thirds of 2002.
However, Amex contends that Island’s success is partially due to its ability to “trade
through” better prices on a consistent basis, a practice not allowed for participants in the