Disintermediating the market

The big financial houses are big and getting bigger and bigger. After the Crash of '29, most governments felt that such financial aggrandisement was not a good thing, and contributed to the crash. Particularly, they wanted to keep the business of banking separate from the business of broking and market making. But that is now just so old fashioned and stands squarely in the way of globalisation of the financial services industry. Or so we are told.

And so the big boys with all the money are gradually occupying all the space of the financial universe. (See, e.g., Too big for its breaches?) This story describes how big money is even marginalising stock exchanges.

In-house antics dry up bourses' liquidity, May 08
By Kevin Drawbaugh | Reuters (you'll need a ticket)

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 United States 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 bypass 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 say the new directive could have a big impact on continental exchanges.

In the US, the consulting firm Celent estimates internalisation accounted for 50per cent of 2004 Nasdaq transactions, up from 25per cent in 2000. On the New York Stock Exchange, Celent says 10per cent of 2004 transactions were internalised, up from half that in 2000.

"We are seeing firms expanding their efforts to develop internal markets for internalisation," says 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."

The trend concerns some US regulators. For while internalisation is already allowed in the US, 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 not exposed to the many bids and offers found on an exchange.

But the 2004 Celent study found that the quality of order execution was no lower at firms that practised internalisation.

Experts say internalisation is one reason bourses are keen to merge and obtain economies of scale. 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.