Dr. P.V. Viswanath

pviswanath@pace.edu

Bid/Ask Spreads

© P.V. Viswanath, 2005

(Incomplete)

• Negative Externalities of Paying for Order Flow

Negative Externalities of Paying for Order Flow (Stoll, 2001)
Price matching occurs when market makers in a satellite market promise to match the best price in the central market for orders sent to them rather than to the central market. The retail broker usually decides which market maker receives the order flow. Not only is the broker not charged a fee, he typically receives a payment (of one to two cents a share) from the market maker. Price matching and payment for order flow are usually bilateral arrangements between a market making firm and a retail brokerage firm.

Price matching violates time priority. When orders are sent to a price matching dealer, they are not sent to the market that first posted the best price. Consequently the incentive to post limit orders is reduced. The limit order may be stranded. Similarly, the incentive of dealers to post good quotes is eliminated if price matching is pervasive. A dealer who quotes a better price is unable to attract additional orders because orders are preferenced to other dealers who match the price. Furthermore, the dealer earns less on the order flow he does retain.

Why do market-making firms pay for order flow?
If prices are non-equilibrium prices, if they are fixed, or if the market makers have monopoly power, then clearly they would want to maximize volume. In such a world, market makers would provide brokerage firms with free research, and other incentives to obtain order flow.

Even though the market-maker has to match the best quote, it does not run the risk it would if it had to post its own quote and have prices move against it, or have informed traders trade against it. By buying order-flow, the market maker is able to circumvent time priority.

A similar practice is the payment of liquidity fees by ECNs to brokers. This provides liquidity to ECNs.

Stoll, Hans. 2001. Market Microstructure. Working Paper no. 1-16, Owen Graduate School of Management, Vanderbilt University.

Handa, Puneet and Robert Schwartz. 1996. "Limit Order Trading," The Journal of Finance, v. 51, no. 5, December, pp. 1835-1861.