| Abstract: |
The paper documents important differences in payment for order flow (PFOF),
spreads, and price improvement across asset classes. In stocks, we show that
PFOF is small. While many retail trades are executed off-exchange, we find
that they receive meaningful price improvement, particularly when spreads are
at their minimum. In single-name equity options, we show that PFOF is large.
While all option trades are executed on-exchange, option exchanges have rules
that facilitate internalization. We exploit variation in the Designated Market
Maker (DMM) assignments at option exchanges to show that retail traders
receive less price improvement, and worse prices, from those DMMs who pay PFOF
to brokers, costing retail investors billions per year. Current debate
concerning PFOF has focused on equity routing. We show that option routing is
comparatively worse, and this gives rise to a second potential conflict of
interest of brokers: encouraging customers to trade assets offering higher
PFOF. As fintech has eliminated retail commissions, these cross-asset
differences in PFOF have become far more consequential to broker incentives. |