Trade Internalization Scrutinized

Terry Flanagan

Internalization, the practice whereby orders get matched on a broker-dealer dark pool without getting exposed on lit markets, is a hot topic in equity trading. Some observers of market structure feel the practice has legitimizing front-running.

“When the counterparty is filling you, and it’s not a natural fill, let’s say a high-frequency seller or a wholesaler who’s internalizing it, they will internalize always at times when it is beneficial for them,” said Nitin Gambhir, chief executive of Tethys Technology. “You essentially have adverse selection, which means if you were to look at the market price as to what it does after you get filled on that order, you will see consistently it will move against you.”

In other words, so-called natural buyers and sellers are getting ‘disintermediated’ by broker-dealer dark pools and high-frequency trading shops, according to Gambhir.

Tethys Technology is a financial software development and market-structure research company. The company has two areas of focus: high performance trading and portfolio management software development, and market-structure research focused on developing analytics to achieve optimal trade-execution.

“About 30% of orders today are getting executed off exchange, so it’s a significant market share,” said Gambhir. “We allow our clients to route orders to the most optimal destinations, where there’s least information leakage and best probability of execution. The idea behind this is to give our clients a continuous perspective on what level of activity is happening in each of the dark pools, as well as how to make decisions about routing to minimize information leakage.”

There’s a common misconception among buy-side traders and even mid-tier sell-side traders that they control where the order is being routed. “The order routing is basically dictated by the algorithm and the smart order router,” Gambhir said. “The key decisions for the firms who are routing orders is which algos they are using.”

Information leakage occurs as a result of “pseudo-internalization, which dark pools do, and even to some degree, public exchanges,” said Gambhir. “That pseudo-internalization is basically where the broker dealer who’s running the dark pool has entered into a business arrangement with a third party, which could be a high-frequency firm or a market maker to essentially internalize on their behalf.”

The result, he said, is that a customer who wishes to buy a stock that’s trading 25.00-25.02 will end up paying the full two cents spread, due to “adverse selection.”

“If there’s 100% internalization, that means you always pay the full spread,” said Gambhir. “You could never place a bid at $25 or even $25.01 and hope to get filled. If anybody is trying to sell to me at that price, the wholesaler or a high-frequency guy will step ahead of me and get that fill.”

Featured image via VERSUSstudio/Dollar Photo Club

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