Payment for Order Flow And Option Internalization

Ernst, Thomas; Spatt, Chester S.

doi:10.2139/ssrn.4056512

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Payment for Order Flow And Option Internalization

56 Pages Posted: 4 Apr 2022 Last revised: 4 Mar 2024

See all articles by Thomas Ernst

Thomas Ernst

University of Maryland - Robert H Smith School of Business

Chester S. Spatt

Carnegie Mellon University - David A. Tepper School of Business

There are 2 versions of this paper

Date Written: March 13, 2022

Abstract

We investigate execution quality and payment-for-order-flow (PFOF) in the options market. Option trades generate high PFOF. While all option trades execute on-exchange, option exchange rules facilitate internalization by retail wholesalers. We exploit variation in designated market maker (DMM) assignments, minimum tick size, and auction allocation rules, showing that option internalization is imperfectly competitive. These imperfectly competitive rules protect option market maker profits, and allow market makers to pay high prices for retail option order flow.

Keywords: Payment for Order Flow, PFOF, Broker, Routing, Options, Robinhood

JEL Classification: G14, G11, G12, G20

Suggested Citation: Suggested Citation

Ernst, Thomas and Spatt, Chester S., Payment for Order Flow And Option Internalization (March 13, 2022). Available at SSRN: https://ssrn.com/abstract=4056512 or http://dx.doi.org/10.2139/ssrn.4056512