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January 1, 2005

Does the Customer Get Hurt by Internalization?

By Staff Reports

Trading against a client's stock orders is not necessarily bad. Indeed, internalization does not hurt efforts to achieve best execution. Those are two of the conclusions of a new study on execution and routing practices in the U.S.

"While internalization may appear nefarious, this study found no evidence that brokerage firms that heavily internalized orders suffered from execution quality inferior to that of brokerage firms that did not engage in internalization or did so in a limited fashion," noted the study by industry consultant Celent Communications. The report also said that the degree of a firm's internalization had nothing to do with its execution efficiency.

The study rated firms on price, speed and overall execution quality. The best firm for price was UBS followed by Bear Stearns and Citigroup in second and third places, respectively. The fastest, in the same order, were Morgan Stanley, NFS (Fidelity) and Charles Schwab. In the overall category, the winner was Citigroup followed by NFS and Goldman Sachs.

Nevertheless, the study's author, while giving internalization a clean bill, endorsed the SEC's renewed efforts to obtain better prices for investors. "Customer orders are frequently executed at prices worse than those available on public markets," said Octavio Marenzi, CEO of Celent. He added that in the second quarter of 2004, about 20 percent of all orders, "were executed at prices worst than the best prices visible on the public markets."

Trading firms typically execute internalized orders at the National Best Bid and Offer, or NBBO. This process is called price matching. "While this is the general business practice, there is no hard and fast requirement for broker dealers to match the NBBO and the term best execution has not been clearly defined by U.S. regulators," according to Celent.