Publication Type

Journal Article

Version

publishedVersion

Publication Date

4-2024

Abstract

We study liquidity supply in fragmented markets. Market makers intermediate heterogeneous order flows, trading off spread revenue against inventory costs. Applying our model to payment for order flow (PFOF), we demonstrate that portfolio-based considerations of inventory management incentivize market makers to segment retail orders by siphoning them off-exchange. Banning order flow segmentation reduces total welfare, can make trading more costly for all investors, and can resolve a prisoner's dilemma among market makers. These results differentiate our inventory-based model from the existing information-based theories of PFOF.

Keywords

Inventory management, Market making, Order flow segmentation, Payment for order flow, Retail trading

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Journal of Financial Economics

Volume

154

First Page

1

Last Page

23

ISSN

0304-405X

Identifier

10.1016/j.jfineco.2024.103807

Publisher

Elsevier

Copyright Owner and License

Authors

Additional URL

https://doi.org/10.1016/j.jfineco.2024.103807

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