Payments for Order Flow on Nasdaq

We present a model of Nasdaq that includes the two ways in which marketmakers compete for order f low: quotes and direct payments. Brokers in our model can execute small trades through a computerized system, preferencing arrangements with marketmakers, or vertical integration into market making. The comparative statics in our model differ from those of the traditional model of dealer markets, which does not capture important institutional features of Nasdaq. We also show that the empirical evidence is inconsistent with the traditional model, which suggests that preferencing and vertical integration are important components in understanding Nasdaq. THE TRADITIONAL MODEL OF DEALER MARKETS assumes a competitive market among marketmakers who actively adjust their quotes to compete for order f low. Although such a model is still implicitly assumed in most of the empirical literature, it ignores important institutional features of actual dealer markets such as Nasdaq. In particular, it does not take into account the variety of alternatives available to brokers to achieve execution of their order f low, or the ability of marketmakers to compete in ways other than through their quotes. For example, Nasdaq marketmakers can purchase orders from brokers under preferencing arrangements, which involve explicit payments by dealers to brokers.1 Brokers can vertically integrate into market making and handle execution of their orders internally; this practice is referred to as internalization. Our goal in this paper is to develop a more realistic model of a dealer market and to contrast its predictions with those of a traditional model that assumes competition only through quotes. * Kandel is at Hebrew University; Marx is at the University of Rochester. We thank an anonymous referee, Mike Barclay, Rob Battalio, Hank Bessembinder, Bhagwan Chowdry, Bill Christie, Darrell Duffie, Jason Greene, Larry Harris, Charles Lee, Ananth Madhavan, Maureen O’Hara, Paul Pf leiderer, Paul Schultz, René Stulz ~the editor!, Avanidhar Subrahmanyam, and the participants of workshops at Arizona State, Berkeley, Cornell, Hebrew, Laval, Stanford, University of California Los Angeles, and the University of Southern California for helpful discussions. This paper was presented at the Charles Dice Conference on Dealer Markets at Ohio State. Kandel thanks the Harvey Krueger Center for financial support. 1 Payments in 1995 were as high as three cents per share. Contracts specify the nature of orders the dealer must accept—small orders for stocks that trade above a certain price and have a quoted spread above some minimum amount. Additional restrictions typically require that brokers send all qualified orders to the same dealer, that there be at least a minimum order f low per month, and that there be no limit orders, professional orders, or program orders. Stocks with a tick size of one-sixteenth or less are frequently excluded ~see NASD Report ~1991!!. THE JOURNAL OF FINANCE • VOL. LIV, NO. 1 • FEBRUARY 1999