Payment for Order Flow and Option Internalization

Abstract

We investigate execution quality and payment-for-order-flow (PFOF) in the options market. Option trades generate high PFOF. While all option trades execute on-exchange, option exchange rules facilitate internalization by retail wholesalers. We exploit variation in designated market maker (DMM) assignments, minimum tick size, and auction allocation rules, showing that option internalization is imperfectly competitive. These imperfectly competitive rules protect option market maker profits, and allow market makers to pay high prices for retail option order flow.

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