A General Analysis of Brokers' Trading, With Applications to Order Flow Internalization and Off-Exchange Block Sales

Abstract

We study a variety of issues related to brokers' trading. In our model, multiple informed traders and noise traders 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). With a fixed number of traders, and relative to consecutive dual trading, informed and noise traders are worse off, brokers are better off, and market depth is lower in the simultaneous dual trading market. When we endogenize the number of brokers, informed and noise traders choose one (all) broker(s) in the simultaneous (consecutive) dual trading market. If the entry cost is low, more informed traders enter the simultaneous dual trading market and market depth may be higher relative to consecutive dual trading. If the entry cost is high, consecutive dual trading is better. We study order flow internalization by broker-dealers, and show that, in the free entry equilibrium, internalization hurts retail customers and market quality; and that it is likely to be more prevalent in thin markets with few informed traders. Finally, we examine off-exchange block sales and find that, compared to exchange transactions, they are more liquid but less informative.