Payments for order flow on Nasdaq

We present a model of Nasdaq that includes the two ways in which marketmake rs compete for order flow: quotes and direct payments. Brokers in our model can execute small trades through a computerized system, preferencing arran gements with marketmakers, or vertical integration into market making. The comparative statics in our model differ from those of the traditional model of dealer markets, which does not capture important institutional features of Nasdaq. We also show that the empirical evidence is inconsistent with t he traditional model, which suggests that preferencing and vertical integra tion are important components in understanding Nasdaq.