A Model of Brokers? Trading, with Applications to Order Flow Internalization, Insider Trading and Off-Exchange Stock Sales
Posted: 25 Jun 1997
Date Written: May 1997
Multiple informed traders and noise traders pay fees to trade through multiple brokers. Brokers may trade with their customers in the same transaction (called simultaneous dual trading) or trade after their customers in a separate transaction (called consecutive dual trading). Since brokers? fees are competitively determined, they are indifferent between simultaneous and consecutive dual trading. If the number of brokers exceeds the number of informed traders, then informed traders prefer consecutive dual trading, and allocate their orders to one broker. If the number of brokers is less than the number of informed traders, informed traders prefer simultaneous dual trading in markets with many brokers and informed traders and allocate their orders to all available brokers. Noise traders always prefer consecutive dual trading, and market depth and price informativeness are always higher with consecutive dual trading. We use our model to study order flow internalization by broker-dealers. Finally, interpreting brokers as follow-on traders, we discuss off-exchange stock sales and explain certain puzzling results related to insider trading events.
JEL Classification: G12
Suggested Citation: Suggested Citation