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A Model of Broker's Trading with Applications to Order Flow Internalization

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  • Chakravarty, Sugato
  • Sakar, Asani

Abstract

Although brokers trading is endemic in securities markets, the form of this trading differs between markets. Whereas in some securities markets, brokers may trade with their customers in the same transaction (simultaneous dual trading or SDT), in other markets, brokers are only allowed to trade after their customers in a separate transaction (consecutive dual trading or CDT). We show theoretically that, informed and noise traders are worse off and brokers are better off while market depth is lower in the SDT market. Thus, given a choice, traders prefer fewer brokers in the SDT market compared to the CDT market. With free entry, however, market depth may be higher in the SDT market provided its entry cost is sufficiently low relative to the CDT market. We study order flow internalization by broker-dealers, and show that, in the free entry equilibrium, internalization hurts retail customers and market quality.

Suggested Citation

  • Chakravarty, Sugato & Sakar, Asani, 2001. "A Model of Broker's Trading with Applications to Order Flow Internalization," Purdue University Economics Working Papers 1150, Purdue University, Department of Economics.
    • Handle: RePEc:pur:prukra:1150
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    References listed on IDEAS

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    1. Sugato Chakravarty, 1994. "Should actively traded futures contracts come under the dual‐trading ban?," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 14(6), pages 661-684, September.
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    5. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1996. "Cream-Skimming or Profit-Sharing? The Curious Role of Purchased Order Flow," Journal of Finance, American Finance Association, vol. 51(3), pages 811-833, July.
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    7. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
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    11. Battalio, Robert & Greene, Jason & Jennings, Robert, 1997. "Do Competing Specialists and Preferencing Dealers Affect Market Quality?," The Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 969-993.
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    Citations

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    Cited by:

    1. He, Chen & Odders-White, Elizabeth & Ready, Mark J., 2006. "The impact of preferencing on execution quality," Journal of Financial Markets, Elsevier, vol. 9(3), pages 246-273, August.
    2. Anand, Amber & Chakravarty, Sugato & Martell, Terrence, 2005. "Empirical evidence on the evolution of liquidity: Choice of market versus limit orders by informed and uninformed traders," Journal of Financial Markets, Elsevier, vol. 8(3), pages 288-308, August.
    3. Zhang, Qiyu & Zhang, Xiaoxiang & Chen, Ding & Strange, Roger, 2022. "Market discipline or rent extraction: Impacts of share trading by foreign institutional investors in different corporate governance and investor protection environments," International Review of Financial Analysis, Elsevier, vol. 79(C).
    4. Chakravarty, Sugato & Li, Kai, 2003. "An examination of own account trading by dual traders in futures markets," Journal of Financial Economics, Elsevier, vol. 69(2), pages 375-397, August.
    5. Alexander, Gordon J. & Peterson, Mark A., 2007. "An analysis of trade-size clustering and its relation to stealth trading," Journal of Financial Economics, Elsevier, vol. 84(2), pages 435-471, May.
    6. FOUCAULT, Thierry & LESCOURRET, Laurence, 2001. "Information sharing, liquidity and transaction costs in floor-based trading systems," HEC Research Papers Series 742, HEC Paris.
    7. Cimon, David A., 2021. "Broker routing decisions in limit order markets," Journal of Financial Markets, Elsevier, vol. 54(C).
    8. Frantisek Kopriva, 2008. "Source of Information-Driven Trading on the Prague Stock Exchange," CERGE-EI Working Papers wp365, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    9. Norris L. Larrymore & Albert J. Murphy, 2009. "Internalization And Market Quality: An Empirical Investigation," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 32(3), pages 337-363, September.
    10. Lescourret, Laurence & Robert, Christian Y., 2006. "Preferencing, internalization and inventory position," ESSEC Working Papers DR 06017, ESSEC Research Center, ESSEC Business School.

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    More about this item

    Keywords

    dual trading ; informed traders ; internalization ; piggybacking ; adverse selection;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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