Institutional Liquidity Demand and the Internalization of Retail Order Flow: The Tail Does Not Wag the Dog

The decision of wholesalers to internalize retail order flow primarily reflects institutional liquidity demand. We first use Tick Size Pilot to highlight this decision's influence on the retail trade imbalances denoted Mroib by Boehmer et al. (2021). We then show that wholesalers internalize more retail order flow when institutional demand is higher, leading Mroib to be inversely related to institutional order flow. Intraday returns move in the same direction as institutional price pressure but the opposite direction of Mroib. Moreover, |Mroib| is highest when institutional trading costs are highest. Distant future returns display strong U-shaped patterns conditional on Mroib, consistent with a permanent liquidity premium driving the positive relation between these returns and the magnitude of |Mroib|. Indeed, |Mroib| provides an easy-to-construct stock liquidity measure that, unlike existing liquidity measures, is priced post 2010, with an annualized liquidity premium of 4%.