Internalized Retail Order Imbalances and Institutional Liquidity Demand

Abstract

Using their exclusive access to retail order flow, wholesalers internalize unequal amounts of retail buy and sell orders to provide liquidity to institutional investors. Shocks to revenues/costs of internalization reveal that wholesaler choices determine observable internalized retail-trade imbalances. Large imbalances signify scarce institutional liquidity, manifested in high institutional trading costs. Consistent with internalized orders providing liquidity rather than being informed, intraday returns move in the same direction as institutional trading but the opposite direction of retail trade imbalances reflecting wholesalers intermediating between retail and institutional investors. The subsequent unwinding of institutional price pressure underlies the positive return predictability of imbalances.

Keywords: Retail Trade, Institutional Trade, Payment for Order Flow, Internalization, Liquidity, Microstructure

JEL Classification: G12, G14