We present a microstructure model of competition for order flow between exchanges based on liquidity provision. We find that neither a pure limit order market (PLM) nor a hybrid specialist/limit order market (HM) structure is competition-proof. A PLM can always be supported in equilibrium as the dominant market (i.e., where the hybrid limit book is empty), but an HM can also be supported, for some market parameterizations, as the dominant market. We also show the possible coexistence of competing markets. Order preferencing—that is, decisions about where orders are routed when investors are indifferent—is a key determinant of market viability. Welfare comparisons show that competition between exchanges can increase as well as reduce the cost of liquidity.

We present a microstructure model of competition for order flow between exchanges based on liquidity provision. We find that neither a pure limit order market (PLM) nor a hybrid specialist/limit order market (HM) structure is competition-proof. A PLM can always be supported in equilibrium as the dominant market (i.e., where the hybrid limit book is empty), but an HM can also be supported, for some market parameterizations, as the dominant market. We also show the possible coexistence of competing markets. Order preferencing—that is, decisions about where orders are routed when investors are indifferent—is a key determinant of market viability. Welfare comparisons show that competition between exchanges can increase as well as reduce the cost of liquidity.

We develop a dynamic model of price competition in broker and dealer markets. With no payment for order flow, a zero-profit equilibrium exists. With payment for order flow, spreads widen to more than compensate for this payment; hence, there is no equilibrium in which market makers earn zero profits. While brokerage commissions for market orders can fall, the total transactions cost to submitting a market order remains positive. Consumer and social welfare are both lower in any equilibrium with payment for order flow; payment for order flow redistributes payoffs from traders who demand liquidity to those who supply it.