Siphoned apart: A portfolio perspective on order flow segmentation

Markus Baldauf, Joshua Mollner and Bart Zhou Yueshen

Journal of Financial Economics, 2024, vol. 154, issue C

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: Order flow segmentation; Payment for order flow; Inventory management; Market making; Retail trading (search for similar items in EconPapers)
JEL-codes: D47 G12 G18 G24 (search for similar items in EconPapers)
Date: 2024
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:154:y:2024:i:c:s0304405x24000308

DOI: 10.1016/j.jfineco.2024.103807

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