To Pay or Be Paid? The Impact of Taker Fees and Order Flow Inducements on Trading Costs in U.S. Options Markets

Abstract

Equity options exchanges in the United States use one of two models to execute marketable orders: the maker-taker model or the payment for order flow (PFOF) model. Exchanges utilizing the maker-taker model charge liquidity demanders a taker fee to access their liquidity. Exchanges utilizing the PFOF model use order flow payments to attract marketable retail orders. We examine whether the agency problems associated with PFOF manifest themselves in the equity options markets. Focusing solely on execution prices, we find that the cost of liquidity on exchanges utilizing the PFOF model is 80 bps higher than on exchanges utilizing maker-taker pricing. Nevertheless, when taker fees are incorporated into the analysis, the cost of liquidity on the PFOF exchanges is 74 bps lower. Our results have two implications: (i) transparency and competition in equity options markets appear to have limited the potential agency problems, and (ii) evaluations of market quality that ignore taker fees can be misleading.

Keywords: options markets, payment for order flow, maker-taker model

JEL Classification: G10, G19