INTERNALIZATION IN OTC AND EXCHANGE-LISTED MARKETS
The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers' orders at prices that leave the banks with undisclosed but huge profits.
How do we know that the profits are huge? Just look at the banks’ quarterly financial reports on derivatives dealings. Even the more modest estimates exceed $100 billion per year, worldwide. Customers are on the other side of those trades. Customer losses are on the other side of those bank profits. The amazing thing is that those banks are able to convince their customers that this is good for them and moving these contracts on to the exchanges would harm the customers.
How do they do this? What dark arts do they employ to maintain the status quo? I think their magic consists of such mundane things as million dollar paychecks to the salesmen, golf outings, tickets to games, dinners, Cuban cigars and probably some other blandishments that should not be discussed in polite company.
And of course, the fact that most OTC derivatives "customers" are not playing with their own money. The customers are finance or investment staff that work for large corporations, state or municipal governments, pension funds and insurance companies. These end-user employees get to drink the fine wines, but it is the shareholders or taxpayers that pay for the overpriced derivatives.
This same thing is happening in more subtle ways in exchange listed products. In Europe, investors have a long tradition of investing through their banks. Smaller banks work with larger banks that sit on exchange boards. The boards make rules for the exchanges that allow the trades to take place not at the exchange but somewhere else, merely being reported to the exchange for clearing. As long as the price is anywhere between the lowest bid and the highest offer that was posted on the exchange any time during the day, it is accepted. Some exchanges will accept a trade as long as it is priced anywhere within 10% of the posted bid or offer.
In these scenarios the exchanges’ traditional function – matching competing bids and offers, resulting in price discovery -- is not used by the brokers, but the brokers are willing to pay the same amount in fees to the exchanges just for the clearing. So the exchanges get the same revenue either way. But I ask you: Is this sustainable? Is there real value added? Is this a healthy, vibrant business model? Or will these exchanges atrophy like unused limbs?
In the U.S., the picture is not very different. Brokers internalize stock trades and put them up at the clearinghouse. They at least are supposed to provide best execution, but best execution is vaguely defined and poorly enforced. Brokers in the U.S. must post reports showing where they route their customers' orders. But do you suppose that brokers care what's reflected in those reports? They do not.
It should be shocking, but it probably is not, that according to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers!
These brokers ignore the exchanges and sell the orders to internalizers, thereby avoiding exchange fees and getting a nice little payment from the internalizers in return. This payment for order flow adds up to real money after millions of orders are taken into account. The internalizers are supposedly matching the best prices prevailing at the exchanges, so that they can argue that the customers get the best prices.
But do they really? Of course not. If they did, an independent study would not have found that the one broker that actually routes the vast majority of its orders to public exchanges -- and I will not name this broker again – obtains executions that are on the average 28 cents better per 100 shares in the U.S., and an absolutely stunning 2.84 Euros better per 100 shares in Europe. As much as I love this brokerage firm, it may not be doing anything all that special. It is mostly just quickly routing each order, or parts of an order, to the public exchange with the best posted prices for that order, and quickly rerouting if another exchange becomes more favorable.