Mixology: Order Flow Segmentation Design

Abstract

I analyze the welfare consequences of segmentation in financial markets. Venues vary in their mixture of information-motivated versus liquidity-motivated order flow. In a simple model, I consider the combinations of information-motivated investor welfare and liquidity-motivated investor welfare that can be achieved by some segmentation. This set’s Pareto frontier can (under certain conditions) be implemented by a simple class of segmentations, in which a fraction of information-motivated flow is segregated, while the remainder pools with liquidity-motivated flow. These results call into question the wisdom of the current regulatory framework as it applies to segmentation, e.g., in U.S. equities.

Keywords: adverse selection, cream-skimming, segmentation, third-degree price discrimination

JEL Classification: D47, D82, D83, G14, G18