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August 31, 2004

Internalization Targeted by the Regulators

By Gregory Bresiger

Big firms that rely on internalization may now be in the crosshairs of regulators re-examining best execution rules.

The Securities and Exchange Commission is looking more closely at internalization, trying to determine if it is leading to higher retail execution costs. That's according to an observer who covers the industry for institutional clients.

"We are hearing," wrote Ken Worthington, an analyst with CIBC World Markets, "that the SEC is starting to more actively look at firm executions, using 11Ac1-5 and 11Ac1-6 data to determine if firms that internalize are delivering the best execution to customer trades that are internalized."

"It is obvious that internalization would be one place to go to see if execution costs are higher than they think they should be," Worthington said in an interview. A trading executive says he had not heard this. However, he says the SEC would likely be continuing with its investigation of best execution. "I would expect that this will continue," says Mark Madoff, head of Nasdaq trading at Bernard L. Madoff Investment Securities.

Worthington says that firms that internalize may be in trouble. The SEC has been employing a formal risk-based formula in brokerage audits, an SEC official earlier this year told Traders Magazine. Best execution is "a key focus of the examinations."

Lori Richards, director of the SEC's Office of Compliance Inspections and Examinations, says that this is a response in part to the "increasing recognition that there are alternative execution venues available."