Order routing and market quality: Who benefits from internalisation?

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.