Competition for Retail Order Flow and Market Quality

Abstract

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