Abstract
We study liquidity supply in fragmented markets. Market makers intermediate heterogeneous order flows, trading off spread revenue against inventory costs. Applying our model to payment for order flow (PFOF), we demonstrate that portfolio-based considerations of inventory management incentivize market makers to segment retail orders by siphoning them off-exchange. Banning order flow segmentation reduces total welfare, can make trading more costly for all investors, and can resolve a prisoner's dilemma among market makers. These results differentiate our inventory-based model from the existing information-based theories of PFOF.
| Original language | English (US) |
|---|---|
| Article number | 103807 |
| Journal | Journal of Financial Economics |
| Volume | 154 |
| DOIs | |
| State | Published - Apr 2024 |
Funding
Nikolai Roussanov was the editor for this article. This paper benefits tremendously from helpful comments by Robert Battalio (discussant), Eric Budish, Isaías Chaves, Darrell Duffie, Naveen Gondhi, Zhiguo He, Shiyang Huang, Vincent van Kervel, Ralph Koijen, John Kuong, Katya Malinova (discussant), Robert McDonald, Maureen O'Hara, Christine Parlour (discussant), Ioanid Roşu (discussant), Gideon Saar, Alvaro Sandroni, John Shim, Konstantin Sokolov (discussant), Viktor Todorov, and the seminar and conference participants at AFA, INSEAD, KU Leuven, Maastricht University, Monash University, Nanyang Technological University, NFA, SAFE Market Microstructure Conference, Singapore Management University, Texas Finance Festival, and Tilburg University. We also appreciate greatly insightful conversations with industry participants. Markus Baldauf gratefully acknowledges support by the Social Sciences and Humanities Research Council of Canada (Insight Grant # 435-2021-1142 ), and he would like to thank the University of Chicago, Booth School of Business, where he was visiting when large parts of this paper were written. We have no competing financial interests. Nikolai Roussanov was the editor for this article. This paper benefits tremendously from helpful comments by Robert Battalio (discussant), Eric Budish, Isaías Chaves, Darrell Duffie, Naveen Gondhi, Zhiguo He, Shiyang Huang, Vincent van Kervel, Ralph Koijen, John Kuong, Katya Malinova (discussant), Robert McDonald, Maureen O'Hara, Christine Parlour (discussant), Ioanid Roşu (discussant), Gideon Saar, Alvaro Sandroni, John Shim, Konstantin Sokolov (discussant), Viktor Todorov, and the seminar and conference participants at AFA, INSEAD, KU Leuven, Maastricht University, Monash University, Nanyang Technological University, NFA, SAFE Market Microstructure Conference, Singapore Management University, Texas Finance Festival, and Tilburg University. We also appreciate greatly insightful conversations with industry participants. Markus Baldauf gratefully acknowledges support by the Social Sciences and Humanities Research Council of Canada (Insight Grant #435-2021-1142), and he would like to thank the University of Chicago, Booth School of Business, where he was visiting when large parts of this paper were written. We have no competing financial interests.
Keywords
- Inventory management
- Market making
- Order flow segmentation
- Payment for order flow
- Retail trading
ASJC Scopus subject areas
- Accounting
- Finance
- Economics and Econometrics
- Strategy and Management