PaymentforOrderFlow.pdf40

1 Introduction
Retail order
ow is a valuable commodity. It is purchased by market makers either
for direct cash payments,1 by payment in services (for example, Merrill has a clearing
arrangement with Knight Securities) or through a?liation arrangements (e.g., Schwab
and Mayer{Schweizer).2 In US equities markets, such trade has been common practice
for 20 years. More recently it emerged in options markets after the explosion of
multiple listings in 1999.3 In March 2001, the SEC issued an \Execution Quality
Disclosure Rule," which will require both market centers and brokers to provide order
execution statistics and information on order routing, in part to address concerns
about the e ect of payment for order
ow on prices paid by retail investors.
Despite the prevalence of this practice, it is an open policy question whether
payment for order
ow impedes competition in a dealer market. A common intuition
is that consumers only care about the total price they pay for executing a trade: that
is, the spread they are exposed to and the intermediation cost they have to pay to
brokers. If payment for order
ow is simply a transfer from market makers to brokers,
then, given erce competition in the retail broker market, such transfers should
ow
back to the consumer either through lower commission costs (some evidence of this
is found by Battalio, Jennings, and Selway, 2000) or through trading enhancements
(such as easy to navigate web
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