A Counterfactual Approach to Modeling Consumer Outcomes With and Without Payment for Order Flow

Abstract

We study the market mechanism of payment for order flow, forming a theoretical framework for understanding the spreads in equilibrium with and without payment for order flow. Our goal is to determine conditions under which retail customers are better off in a market without payment for order flow compared to with payment for order flow, and combine this with market constraints that allow payment for order flow to exist. We propose a general model into which different market characteristics can be plugged in to determine equilibria, formed based on changing levels of nontoxic flow into the open exchange based on the presence or absence of payment for order flow. After solving for our general model, we examine an SEC proposal for amendments to the structure of payment for order flow, and also examine strategic behavior in the equilibrium with payment for order flow and its implications on retail customer outcomes. Finally, we examine practical limitations of our model and look to future work for continued development of our understanding of payment for order flow.