A Simple Model of Payment For Order Flow, Internalization, and Total Trading Costs
2001, Journal of Financial Markets
Robert Battalio, Craig W. Holden
We show that externally-verifiable characteristics (inexpensive for a third-party to verify) of traders or orders allow pro"table purchasing of order flow and internalization. We introduce total trading cost, defined as the effective half spread plus the broker's per share commission, as a measure of execution quality. We use this measure to reinterpret prior empirical studies of: (1) execution quality across trading venues and (2) cream-skimming by purchasers of order flow. Finally, we show brokers can use their direct relationships with customers to assess internally-verifiable characteristics (inexpensive for direct verification) in order to increase profits extracted from customer orders.
Battalio, Robert and Craig W. Holden (2001), “A Simple Model of Payment For Order Flow, Internalization, and Total Trading Costs,” Journal of Financial Markets, Vol. 4, pp. 33-71.