Competition and Payment for Order Flow in Options
Payment for order flow (PFOF) impacts competition through potential agency issues in order routing and execution. Regulation prevents off-exchange internalization in options, so exchanges offer price-improvement auctions. Auctions receive large price improvement and have lower trading costs and market maker revenues. PFOF wholesalers are often designated market makers (DMMs) on exchanges. Exchange market share, non-auction market maker revenues, and auction price improvement are higher for PFOF DMMs. PFOF DMMs with lower recent execution quality are more likely to run auctions and offer better executions. These results are consistent with PFOF encouraging competition in auctions, but potentially hindering non-auction competition.