A general model of brokers' trading, with applications to order flow internalization, insider trading and off-exchange block sales

Multiple informed traders and noise traders pay fees to trade through multiple brokers. Brokers may trade with their customers in the same transaction (simultaneous dual trading) or trade after their customers in a separate transaction (consecutive dual trading). Brokers' expected profits from fees and trading, net of brokerage costs, are zero and so brokers are indifferent between simultaneous and consecutive dual trading. Market depth and price informativeness are higher with consecutive dual trading, compared to both simultaneous dual trading and the no-dual-trading benchmark. If the number of brokers exceeds the number of informed traders, then both noise traders and informed traders prefer consecutive dual trading. If the number of brokers is less than the number of informed traders, however, net informed profits and net uninformed losses may be higher with simultaneous dual trading in markets with many brokers; net informed profits and net uninformed losses are higher with consecutive dual trading in markets with relatively few brokers. We use our model to study order flow internalization by broker-dealers. Finally, we interpret brokers as "follow-on traders" whose trading is derived from the order flows of preceding traders. With this broader definition, we (1) explain certain puzzling empirical results related to the effect of insider trading on non-insider trading volume and market liquidity; and (2) discuss large block sales conducted off the exchange floor by insiders to avoid "follow-on" trading.