We set out to investigate how off-exchange orders such as PFOF help market makers manage the inventory aspect of their business model. This is because excess inventory makes market makers vulnerable to after-hours developments, such as earnings releases or news reports, that could affect share values. To best avoid risk, they ideally want to maintain an inventory that’s as close to zero as possible at the closing bell. Besides accumulating revenue, market makers also need to manage the inventory sitting on their balance sheets. ![]() Our study focuses on the other half of the picture: market makers’ inventory cost to provide liquidity. Market makers are thus incentivised to load up their books with retail orders. The more trades they execute, the higher their revenue. Each time a market maker executes a retail trade, they scoop up revenue from the price-improved bid-ask spread. Much previous research into how PFOF benefits market makers has focused on its effect on their revenue. And in the United States, the Securities and Exchange Commission is looking into regulating PFOF, with chair Gary Gensler previously disclosing that an outright ban was on the table (though this appears to have been put off for now). ![]() It’s currently under review in the European Union, with certain lawmakers calling for a total clampdown on the practice. In fact, PFOF is prohibited in the United Kingdom, where it’s been outlawed since 2012, as well as in Canada and Australia. But some worry that brokers may be incentivised to sell their customers’ orders to the highest bidder, rather than getting the best deal for their clients. For instance, Robinhood reportedly obtains about 80 percent o f its revenue from PFOF. PFOF is popular in many countries and has even become the main source of revenue for some brokers. Meanwhile, the market makers make a profit by charging bid-ask spreads better than the best on-exchange quotes (a "price improvement”) and share a percentage of this with brokers for routing the orders to them. Market makers can offer a better price compared to on-exchange trading, allowing brokers to fulfil their fiduciary duty to get the best price for their clients. Acting as wholesale intermediaries, the market makers then execute these trades against their own balance sheets. In doing so, brokers effectively sell these orders for a fee to heavyweight market makers such as Citadel Securities or Virtu Financial. When retail investors place orders through their brokers, many of these go through a process known as PFOF. By accounting for the business model of market makers, and the various factors they consider when executing trades, we show how banning PFOF could have negative, far-reaching consequences for all market participants, including retail investors. Our research looks particularly at how eliminating PFOF would affect market quality. ![]() But payment for order flow (PFOF), a controversial practice used by many brokers to generate revenue, and in turn provide the aforementioned perks to their clients, has been facing regulatory scrutiny. ![]() Retail investors have their pick of brokers, many of which offer attractive perks such as sign-up bonuses, zero trading commission and waiving custodial charges. Yet, retail investors still make up a robust segment of the equity market, at times accounting for a third of all stock trading in the United States in 2021. The intensity of retail trading has dropped slightly since its pandemic peak – when individual investors, flush with stimulus cheques and looking for a way to spend their money amid global lockdowns, poured into the stock market.
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