Buy or sell - it makes no difference to Wall Street. Brokerages and exchanges take their profits either way out of investors' hides. But in the struggle for the biggest slice of fee income, a practice known as internalisation is spreading and increasingly giving firms that pursue it the upper hand.
Internalisation happens when a brokerage or other financial firm takes a customer's buy or sell order and fills it in-house, instead of sending it out to an exchange.
Challenging the role of exchanges as the central hubs where trading gets done and raising conflict-of-interest questions for investors, the practice is spreading across US markets and is about to undergo a major expansion in Europe.
European Union rules set to take force in November 2007 will legalise internalisation across the 25-nation bloc under the "Markets in Financial Instruments Directive," or MiFID.
MiFID is expected by some to trigger a mini-revolution in how shares are traded in the EU. It was bitterly contested by some exchanges, fearing large order volumes may by-pass them.
In some EU states, exchanges have benefited from a "concentration rule" requiring all share orders up to a certain size to pass through the bourse. MiFID will end this.
The change will make little difference to London, Europe's top financial centre. Internalisation is already allowed in Britain. But experts said the new directive could have a big impact on Continental exchanges.
In the United States, the consulting firm Celent estimated internalisation accounted for 50 percent of 2004 Nasdaq Stock Market transactions, up from 25 percent in 2000.
On the New York Stock Exchange, a unit of for-profit NYSE Group Inc since March, Celent said 10 percent of 2004 transactions were internalised, up from half that in 2000.
"We are seeing firms expanding their efforts to develop internal markets for internalisation," said Ralston Roberts, a senior vice president at financial systems group SunGard.
"As a result of this effort, we are going to see more and more liquidity move off the exchanges," Roberts said.
REGULATORS MONITORING:
The trend concerns some US regulators. For while internalisation is already allowed in the United States, it is normally done only under certain conditions and the US Securities and Exchange Commission monitors it closely. With the exchange industry in a whirlwind of corporate consolidation, technological change and reforms to trading and pricing rules, internalisation is getting renewed attention.
The SEC's 2005 Regulation National Market System rules emphasise investors' ability to get the best prices possible in their dealings.
Internalisation raises questions about whether that goal is always met when orders are filled in-house by a brokerage and not exposed to the many bids and offers found on an exchange.
However, the 2004 Celent study, like some other analyses, found that the quality of order execution was no lower at firms that practised internalisation than at firms that did not. Still, the order execution quality issue lingers.
"Brokers are required to provide the best execution for a customer order that is reasonably available," said SEC Commissioner Annette Nazareth in an interview.
"Internalisation is a permissible practice, although the commission has taken several steps over the years to encourage greater interaction for investor orders, since it is through open and transparent order interaction that the most efficient pricing can be set in the marketplace," said Nazareth.
Experts have said internalisation is one reason bourses are keen to merge and obtain economies of scale. This will allow them to cut trading fees. Brokerages that internalise often argue it saves investors money by avoiding trading fees. Only major investment banks are expected to internalise in the EU, as it will come with strict conditions too costly for small firms to comply with.
For example, banks will have to publish to the broader market the price of a proposed in-house trade before the transaction is completed. Reporting of internalised trades is also required in the United States.
With internalisation cutting into exchanges' business, a key question will be how they respond.
"The exchanges are being quite tepid, particularly in Europe, in fighting back here," said Benn Steil, a senior fellow and director of international economics at the Council on Foreign Relations, a think tank.
The next phase may be for the exchanges to try to "out-internalise" the brokerages, he said, perhaps by going directly after brokerage clients with offers of direct exchange access to hedge funds, for instance.
"Now, they've generally been reluctant to do that, although that is changing," Steil said. "I can assure you this is a very live issue. The commercial incentive for demutualised exchanges to bypass members and go direct to the hedge funds is enormous, meaning it's coming. One way or the other, it's coming."
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