Siphoned Apart: A Portfolio Perspective on Order Flow Segmentation
70 Pages Posted: 4 Aug 2022 Last revised: 28 Mar 2023
Date Written: March 28, 2023
We study liquidity provision in fragmented markets. Market makers intermediate heterogeneous order flows, trading off expected spread revenue against inventory costs. Applying our model to payment for order flow (PFOF), we demonstrate that portfolio-based considerations of inventory management incentivize market makers to segment retail orders by siphoning them off-exchange. Banning order flow segmentation unambiguously hurts welfare, can make trading more costly for all investors, and can resolve a prisoner’s dilemma affecting market makers. These results differentiate our inventory-based model from the existing information-based theories of PFOF.
Keywords: order flow segmentation, payment for order flow, inventory management, market maker, retail investor
JEL Classification: D47, G11, G18
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