Internalization of Orders

October 17th, 2010 by eyal | Filed under Stock Market, Trading Resources. | Print This Post Print This Post

There is a fascinating speech by InteractiveBrokers founder, Thomas Peterffy to the World Federation of Exchanges in Paris posted on IB’s website. It is highly recommended for a look into how the brokers and markets work today from a technical perspective, how your orders are treated and why there is a big problem brewing with transparency, trust, fairness in dealings of exchanges and brokers and ability to handle market meltdowns such as the May flash crash. He seems to take stance that the troubles we’ve been seeing with flash crashes isn’t rooted in algo trading / HFT but with fragmentation of exchanges, clearing houses and ubiquity of internalizers. Here is the gist of it, the full speech is available here in PDF.

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.

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.

The steps he proposes are mainly 3:
1. Forcing brokers to route to exchanges
2. Defragmenting the exchanges.
3. Consolidate clearing houses. Peterffy raises some good questions here about liquidity, solvency and ability of small clearing houses to handle crises.

H/T TraderGav

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8 Responses to “Internalization of Orders”

  1. eyal | 17/10/10

    There were a couple of comments worth mentioning here posted on the Facebook link:

    Mark Moussafir: Do you actualy think that when I give a buy oe sell order through TOS , it ends up in some internalizers ? although you can usually see the route
    that was chosen =through what exchange is it executed .?


    Eyal Maoz: I think that depends on whether you chose a specific exchange to route to. If let’s say you specified Island, then it should be go there rather than to an internalizer. But then you might not get the best execution since a better price might be available elsewhere on another exchange.

    If you’re using TOS’s SMART routing (donno their names for auto routing) then internalizers are possible destinations I guess. Look at your execution report and see if there are other types of routing destinations mentioned, like Knight for example, which is one of the largest internalizers. Also look for information on whether TOS gets any kind of payment for order routing, not sure if they do, I would expect a broker like TOS not to.


    Mark Moussafir: very interesting , I will look in to it ..


    Eyal Maoz: Looks like TOS does get payment and routes to internalizers:

    At least two internalizers are mentioned here Citadel and Citigroup.

    There are very few brokers who can compete with IB in this type of things.

  2. eyal | 17/10/10

    IB does not receive payment from internalizers, but does receive some compensation, such as ECN rebates which sounds reasonable to me.

    Payment for Order Flow – Stocks: IB does not generally accept direct payment for order flow for stock orders. However, several types of payments received by IB for various types of order executions may be considered indirect payment for order flow under SEC nterpretations.
    ECN Rebates: IB receives liquidity rebates from ECNs for certain orders routed to those ECNs, ECN liquidity rebates are credited against the fees charged by the ECNs to execute other orders. ECN rebate amounts change frequently. Rebate rates for most ECNs are posted on the IB website (in the section on unbundled commission costs). They also typically are posted on ECN websites.

  3. Leav | 17/10/10

    Very interesting. Can you see if the order went to the market or to an internalizer?
    This again raises the question: how can IB be that cheap?

  4. eyal | 17/10/10

    You should be able to see which exchange it went to. See my reply to Mark above.

    Why cheap? Several reasons I guess:

    1. They run a very tight ship.
    2. Economies of scale due to size.
    3. They make more money in market making (especially options).
    4. There are even cheaper commissions in prop firms, IB’s rates are cheap for retail traders but the true costs from the exchange etc. are just a fraction of even IB’s low commissions.
    5. Better technology.
    6. Less greedy maybe, remember that in the not so distant past some brokers were charging $15 or even $30 for stocks execution.

  5. Nolan | 5/12/10

    It was an interesting article, but it was also a veiled advertizement for Interactive Brokers in my opinion.

    The basic points seemed to be:
    Interactive Brokers doesn’t make money buying or selling order flow information. Their fills are probably the best you are going to get as a retail trader. If retail business was not longer allowed to go to internalizers, it would have to be routed through brokers like IB, at least until other brokers offered the same routing.

    Market Makers in options shouldn’t have to hold their price quotes as long as they do. IB makes most of its money through options market making. High Frequency Traders are cutting into IB’s profits by picking off the last quotes as prices move.

    If these changes could be made, Interactive Brokers would have a lot easier time making money. What’s good for IB, my friends, is good for the world.

  6. eyal | 6/12/10

    Nolan, yes I see what you’re saying. I have no illusions that Peterffy is unbiased or would ever voice out against his own firm’s interests. Nevertheless IB’s level of transparency and this speech are relatively uncommon amongst brokers.

    Are you trading equities btw or futures?

  7. Nolan | 6/12/10

    I enjoyed the article nontheless. And I think his points are valid. I remember having an options express online account once upon a time.

    Looking back it cracks me up that I could place a market order and get back this, “We are currently working your order.” message when I asked for an order confirmation. Oh, good. Glad to know you are seeing what the best price you might be able to find me for my two contracts. Let me know what you can dig up. I know getting filled at market can take awhile.

    I currently trade equities. I found your site when I was trying to research a cool place to spend a few months and trade in SE Asia or India. I was thinking Chiang Mai, but it sounds like the pollution has gotten worse since I was there a few years ago. And I couldn’t really figure out if the internet connection would be reliable enough for my needs.

  8. eyal | 6/12/10

    Funny, reminds me of how Ameritrade and Datek worked back in 2000 :-)

    Chiang Mai is a nice place to spend a couple of months, it’s a bit small for my taste for a longer term stay. The pollution is seasonal as you probably know, with the burning of fields to clear them up. It’s an issue in a number of countries in SE Asia, even Singapore.

    Another option is Pattaya. It has a bad reputation but overall not a bad place to spend a couple of months in case you really don’t like Bangkok. One added bonus is the beach, and there’s also pretty good variety of international food, and it’s near Bkk.

    As for internet, most ISP’s probably route via Bkk, bound to be slower. Also short term accommodation means less options and flexibility in choosing a provider. Depending on your trading timeframe and amount of data you’re pulling even in Bangkok you might need a higher end connection (i.e. not a normal residential one). If you need any details give me a shout.

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