Internalization and Market Quality in a Fragmented Market Structure

Abstract:     
According to the SEC, US stock trading venues now include 10 public exchanges, more than 30 dark pools, and more than 200 internalizing broker-dealers. A large proportion of the 30 dark pools now largely facilitate internalization by their owners. According to published reports, over three quarters of the order flow executed through dark pools is likely internalized. As the number of trading venues has increased, so too has the percentage of order flow executed off-exchange. Today, one third of NYSE volume and one quarter of NASDAQ volume is reported off-exchange and is largely internalized order flow. This paper examines the impact of this dramatic increase in internalization on market quality. I find, after controlling for factors known to be influential, that internalization is directly related to spread width (quoted, effective, and realized). I also find that the percentage of volume internalized is directly associated with price impact per trade and volatility.

Number of Pages in PDF File: 50

Keywords: Dark pool, internalization, market quality, fragmentation

JEL Classification: G12, G14, G18

working papers series