Order routing and market quality: Who benefits from internalisation?

Paper: arXiv 2212.07827

Authors: Umut Çetin, Alaina Danilova

Abstract

We analyse two models of liquidity provision to determine the retail traders’ preference for marketable order routing. Order internalization is captured by a model of market makers competing for the retail order flow in a Bertrand fashion. On the other hand, the price-taking competitive liquidity providers characterize the open exchange model. We show that, when liquidity providers are risk averse, routing of the marketable orders to the wholesalers is preferred by all retail traders: informed, uninformed and noisy. The unwillingness of liquidity providers to bear risk causes the strategic trader (informed or not) to absorb large shocks in their inventories. This results in mean reverting inventories, price reversal, and lower market depth. The equilibria in both models coincide with Kyle (1985) when liquidity providers are risk neutral. We also identify a universal parameter that allows comparison of market liquidity, profit and value of information across different markets.

Complexity vs Empirical Score

• Math Complexity: 8.0/10
• Empirical Rigor: 2.5/10
• Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper relies heavily on theoretical microstructural modeling, extending Kyle (1985) to incorporate risk-averse liquidity providers and internalization mechanisms. While mathematical derivations are dense and novel, the paper lacks empirical backtesting or real-market order flow data validation.

Research Flowchart

  flowchart TD
    A[Research Goal: Evaluate retail trader preference<br/>between Internalization vs. Open Exchange] --> B[Model Setup: Risk-Averse Liquidity Providers<br/>under Kyle 1985 Framework]
    B --> C[Internalization Model:<br/>Wholesalers via Bertrand Competition]
    B --> D[Open Exchange Model:<br/>Price-taking Competitive LPs]
    C --> E[Comparative Equilibrium Analysis<br/>using Universal Liquidity Parameter]
    D --> E
    E --> F[Findings: Internalization preferred by all retail traders<br/>informed, uninformed, noisy]
    E --> G[Findings: LP Risk Aversion causes mean-reverting<br/>inventories, price reversals, lower market depth]