Why Allow Internalization?

Abstract

Over the last decade, an increasing portion of U.S. equity trading volume has been executed away from public exchanges. A common form of this off-exchange trading is internalization, a practice whereby a brokerage fills a client's order from its own inventory. I develop a model to study the impact of internalization on traders’ behavior and market outcomes. In equilibrium, trades in the limit order book, relative to internalized orders, stem from the more informed traders. The bifurcation of the order flow increases transaction costs for the more informed traders. Consequently, it reduces these traders’ demands and the aggregate trading volume. When all orders are submitted via possibly internalizing broker-dealers, the volume reduction lowers price efficiency. When traders can access the limit order book directly, the concentration of informed flow on the exchange may dominate the impact of the reduced volume: there exists an equilibrium where internalization improves price efficiency.

Keywords: internalization, transparency, limit order book, price discovery, liquidity

JEL Classification: G10, G14