Competition for Retail Order Flow and Market Quality

Abstract

Two market-makers internally executed 70% of retail orders between 2017-2021 ($70 trillion; 19% of total volume). The concentration of retail trading away from exchanges can provide economies of scale, but may reduce competition on exchanges. We find that internalization is associated with higher spreads and worse price improvement, especially for stocks with high internalizer Herfindahl-Hirschman Index (HHI) levels. Experimental findings from the Tick Size Pilot internalization restrictions and internalizer outages during the "meme stock" frenzy support a causal interpretation. We argue that promoting 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