Competition for Retail Order Flow and Market Quality
61 Pages Posted: 3 Apr 2022 Last revised: 7 Oct 2022
Date Written: June 8, 2022
Approximately 27% of trading volume is routed from retail brokerages to seven market-making firms (“internalizers”). We estimate that two of these firms, Citadel and Virtu, handle 70% of this volume, or $70 trillion from 2017-2021. Our theoretical model predicts that spreads are wider in a non-competitive market for retail order flow, as internalizers have less incentive to use their profits to improve on-exchange liquidity. Using the SEC Tick Size Pilot, which restricted internalization in some stocks as a natural experiment, we provide evidence that internalization negatively affects market liquidity, and that this effect is especially strong for stocks with concentrated internalization volume, as measured by our internalizer Herfindahl-Hirschman Index. Our results suggest that promoting more competitive markets for retail order flow could save investors billions of dollars in transaction costs.
Keywords: payment for order flow, retail trading, market quality, internalization, wholesalers, competition
JEL Classification: G12, G18, D43
Suggested Citation: Suggested Citation