Siphoned Apart: A Portfolio Perspective on Order Flow Segmentation

We study liquidity supply in fragmented markets. Market makers intermediate heterogeneous order flows, trading off 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 reduces total welfare, can make trading more costly for all investors, and can resolve a prisoner’s dilemma among 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 making, retail trading

JEL Classification: D47, G11, G12, G18, G24

Suggested Citation: Suggested Citation

Baldauf, Markus and Mollner, Joshua and Yueshen, Bart Zhou, Siphoned Apart: A Portfolio Perspective on Order Flow Segmentation (February 21, 2024). Journal of Financial Economics, volume 154, 2024 [10.1016/j.jfineco.2024.103807], Available at SSRN: https://ssrn.com/abstract=4173362 or http://dx.doi.org/10.1016/j.jfineco.2024.103807