Payments for Order Flow on NASDAQ

We provide a framework for evaluating various proposed changes in the NASDAQ market including a reduction of the minimal tick size, the abolition of preferencing, and measures designed to ensure that market makers do not avoid odd-eighth quotes. We do so by explicitly modeling the interaction between brokers and market makers in the NASDAQ market. The paper focuses on both market maker and broker strategies in an environment where brokers and market makers interact anonymously for small non-preferenced trades, but interact directly for preferenced trades. Brokers in our model can execute trades through SOES or preferencing arrangements with market makers, or by vertically integrating into market making. Market makers choose whether to participate in SOES and whether to enter preferencing arrangements. We do not deal with large trades executed outside of preferencing arrangements. Results for our model indicate that reducing the tick size from one-eighth to one-sixteenth causes the equilibrium payment for order flow to decrease. Abolishing preferencing arrangements causes the total number of market makers to increase. Simulation results show that a decrease in the tick size can result in the elimination of preferencing and vertical integration but can result in an increase in the total number of market makers. Simulation results also show that the avoidance of odd-eighth quotes can result in the elimination of SOES traders. An example illustrates the rather counterintuitive result that a change, such as avoiding odd-eighth quotes, that increases the per-share profit can actually result in a decrease in the number of market makers