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May 10, 2006

SEC's Internalization Review Stirs Debate

By Gregory Bresiger

The Securities and Exchange Commission is right to pursue an investigation into big brokerages' internalization practices.

That's according to New York Stock Exchange officials, who have persistently criticized the much-debated practice. The Big Board comments came amid recent published reports of an SEC investigation into internalization of listed flow.

"We think it (the investigation) is terrific," said Robert McSweeney, senior vice president, competitive position, the New York Stock Exchange. The Big Board has argued that internalization should be banned.

"We have taken a position that internalization is bad public policy," McSweeney told Traders Magazine.

SEC officials looking at big brokerages are said to be questioning if internalizing meets best execution requirements. Many big brokerages have been internalizing listed order flow for the last three years. However, they are still required to obtain the national best bid and offer (NBBO).

However, SEC officials, who have been examining internalization since at least last fall, may be looking at expanding execution standards. Apparently, they have been trying to figure out why some big brokerages have very low execution costs.

SEC officials have said that executing at the NBBO within a brokerage is not a substitute for checking various trading venues for the best prices. Nevertheless, defenders of internalization, noting that the SEC mandated Rule 605 (formerly 11ac1-5) statistics have become commonplace, say the best execution is the point.

"Since these statistics have become ingrained in everyone's analysis and routing practices the argument for and against internalization pretty much washes itself out from our point of view," according to Joe Mecane, a managing director and head of broker services with UBS Investment Bank.

"If your statistics are better than what you can get outside of your firm, then it makes a strong case for internalization," Mecane added. He also argues that internalization "fosters innovation and competition" because it is providing additional venues and ways of executing. UBS, Mecane noted, has spent "a lot of money in building state of the art technology and maintaining very good execution statistics."

Still, McSweeney, in commending the regulators to push on, said the internalization investigation should include more than best execution issues.

"We also believe, beyond best execution questions, there are significant conflicts of interest embedded in that practice (internalization). Public order flow benefits from interacting with other public order flow as opposed to just stopping in the back office of a broker/dealer and interacting with their own proprietary account or other orders that might be resident there," according to McSweeney.

As to potential conflicts of interest, some of NYSE's exchange competitors are suggesting internalization relates to NYSE's fears of no longer enjoying quasi-monopoly powers at a time when it is now a for-profit institution.

"The Big Board," said one executive of a competing exchange, "is obviously fighting to maintain as much market share as possible. So it is understandable that they would try to maintain a monopoly position in aggregating (listed) order flow. But our position is that the listed market place benefits by having a lot more listed flow," said the exchange official.

He also charged that Nasdaq's proposed internalization stats are spooking NYSE.

In February, for example, Nasdaq claimed total Nasdaq market share of 80 percent, with 25.3 percent internalized and 54.7 percent executed on Nasdaq systems. At the same time, Nasdaq claimed total NYSE market share of 21.4 percent, of which 14.4 percent was internalized and 7.0 was completed on Nasdaq systems.