The new, as-yet unnamed internalization system will work with the existing Smart Order Routing System and Order Management System. The new system will be filling the missing part of Ridgecrest trading platform.
Overview of Internalization
Large brokerage firms that have huge amounts of natural liquidity from customers flowing through their trading desks, are offering buy-side traders the ability to cross their trades internally. In some cases, brokers are registering their internal crossing networks as alternative trading systems (ATSs) to make these networks more attractive to the buy side by bringing in regulatory oversight and opening them up to external sources of liquidity.
In simply, this is called crossing the natural flow. The Natural flow is the stream of buy and sell orders that institutional and/or retail customers route through the sell-side trading desks, direct market access (DMA) platforms or algorithmic strategies. Internal crossing enables brokers to potentially match both sides of trades within their own shops.
Advantages of Internalization
- Sell-side firms say the advantage of these internal crossing networks is that they obtain the best price and incur less market impact than if orders were routed externally to exchanges and ECNs (Electronic Communication Networks). They may be buying at the bid or meeting in the middle when they're crossing. They're typically not going to be paying the spread.
- Beyond the obvious spread savings, the liquidity provided by sell-side crossing networks offers the buy side a lower-impact way of trading, because these orders have the opportunity to trade with other natural liquidity directly in addition to participating actively in the market.
- Unlike exchanges and ECNs, which display their quotes, crossing networks' quotes are not displayed and, therefore, offer anonymity, so there is less chance of information leakage. Because the crossing networks are not displaying a quote in the public market, they may not have as much impact as they would if the order was routed to an exchange or ECN. Further, internal crossing networks allow brokers to find matches without paying fees to exchanges and ECNs.
- Brokers that operate crossing networks as ATSs could be entitled to earn market data fees under Regulation NMS (Natinal Market System). If firms match trades internally, they are required to print the trades on an exchange. The exchanges then sell the market data and allocate a portion of the revenues back to their participants. Many of the same firms that are registering ATSs also have taken stakes in regional exchanges. If a firm starts an ATS, it potentially can print the trade on an exchange in which it has an investment and qualify for a share of the market data revenues.
- The trend also is being driven by Wall Street's desire to cut costs in a world of compressed spreads and shrinking commissions. With equity commissions paid to brokers declining from 4 cents or 5 cents per share for traditional block trades to 1 cent or 2 cents a share for algorithmic trades - and even fractions of a penny for DMA trades - there is an economic incentive to cross orders internally before routing outbound.
- ATSs benefits the brokers economically. They would keep both sides of the trades. They would make a commission on both sides of it.
In today's electronic trading environment, brokers also recognize the opportunity to capture more business by registering their crossing networks as ATSs. While the concept of Internalization via automated execution was invented by the Madoffs in the 1970s, according to analysts and trading executives, until recently, most of this sell-side crossing activity was conducted by voice brokers. With the growth of algorithmic trading, through which institutions are slicing and dicing their block orders and routing them electronically, however, brokers are automating the process to match up the orders internally.
While internal broker crossing networks match orders utilizing both customer and principal flows, some of the new crossing networks that are classified as ATSs also are connecting to external liquidity sources, such as external ATS systems as well as ECNs and exchanges.
But boosting liquidity isn't the only reason to register as an ATS. Another reason brokers are registering their crossing networks as ATSs is because the sell-side crossing networks include both customer and principal flows, which makes some buy-side traders uneasy. By filing as an ATS, a sell-side crossing network invites regulatory oversight with the goal of making buy-side traders more comfortable with the service.
Crossing Concerns
- Clients should have a choice between crossing only versus other clients, or trading versus all the available liquidity.
- Brokers that do proprietary trading can aggregate all the data from the crosses to glean information about trading patterns that can then be used to customers' disadvantage.
- Internalization algorithm based issues.
- If they see there are 3 million shares to buy and 100 million shares for sale in their system, how do they deal with that?
- A lot of the ATSs don't print to a tape anywhere. This starts to lose some sense of what the market is; what it's actually doing.
