Market Making, the Tick Size and Payment-for-Order-Flow: Theory and Evidence
Posted: 6 Sep 1999
Date Written: August 1993
This paper analyzes the effects of a finite tick size and the practice of 'payment-for-order-flow' on competition between NYSE and non-NYSE market makers. Due to the presence of non-specialist market makers, order submitters find that their NYSE orders are sometimes executed at better than quoted prices. Our analysis implies that even if the NYSE reservation price is superior to its non-NYSE counterpart, brokers may, due to payment-for-order-flow, prefer to execute orders off the NYSE floor. Further, if, unlike NYSE specialists, non-NYSE market makers can more easily offset their inventory exposure (using, for example, options markets), they offer more competitive prices. In accordance with the implications of the model, we provide empirical evidence that non-NYSE market makers trade a larger fraction of the smaller order sizes and offer fewer price improvement opportunities. Also, large companies appear to have enhanced price improvement opportunities on the NYSE, suggesting that the number of non-specialist market positively affects such opportunities.
JEL Classification: G00
Suggested Citation: Suggested Citation