The Relationship Among Market-Making Revenue, Payment for Order Flow, and Trading Costs for Market Orders

Posted: 22 Aug 2001  

Robert H. Jennings

Indiana University - Kelley School of Business - Department of Finance

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Abstract

We study the division of market-making revenue among dealer, broker, and trader. When Knight Securities, a major Nasdaq dealer, interacts with market orders in actively traded stocks during the fourth quarter of 1996, we estimate that its revenue is $0.057 per share. Knight pays brokers at least $0.025 per share (44% of revenue) for orders. To examine whether brokers appear to share these payments with traders, we compare net trading costs (trade price net of commissions) for traders using brokers routing Knight orders with estimated net trading costs for traders using the only discount broker we can determine did not directly receive market-making revenue. We find that the net trading cost of the broker refusing order-flow payments does not dominate the net trading cost of all brokers selling order flow to Knight. This finding suggests that order-flow payments do not unambiguously harm traders and challenges the conclusions of extant studies using only trade prices to assess market quality.

Keywords: Equity market micro-structure, trading costs, payment for order flow, execution quality

Suggested Citation

Jennings, Robert H., The Relationship Among Market-Making Revenue, Payment for Order Flow, and Trading Costs for Market Orders. Journal of Financial Services Research, Vol. 19, February 2001. Available at SSRN: https://ssrn.com/abstract=280895

Robert H. Jennings (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

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Bloomington, IN 47405
United States
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