Price Improvement and Payment for Order Flow: Evidence from A Randomized Controlled Trial

Abstract

There is ongoing debate as to whether the practice known as “payment for order flow” (PFOF) leads to price improvement for retail investors. In this paper, I use a randomized controlled trial to attempt to answer this question and measure the extent of price improvement. The trial involves trading random stocks at random times across random brokers and comparing execution quality across direct market access and PFOF-based brokers. Consistent with the national best bid and offer (NBBO) not representing the prevailing market conditions, I find that orders executed via direct market access receive significant price improvement relative to the NBBO. Using direct orders as the counterfactual, I find considerable heterogeneity in the extent of price improvement provided by PFOF-based brokers. Brokers deriving comparatively more revenue from PFOF (e.g., Robinhood) provide negligible price improvement, whereas brokers deriving comparatively less revenue from PFOF (e.g., TDA) provide economically and statistically significant price improvement. Collectively, the evidence is consistent with the notion that PFOF benefits retail investors, and that agency problems can prevent brokers from passing these benefits along to their customers.

Keywords: price improvement, payment for order flow, best execution, Robinhood, TD Ameritrade

JEL Classification: C93, G14, G21, G24, G50