Was 2009 the year of the market maker - internalization ?

Discussion in 'Trading' started by ASusilovic, Dec 16, 2009.

  1. We were intrigued by a comment by one of our contacts that 2009, more than anything else, had been the year of the market maker. And that’s on every level.

    Think about it:

    Traditional value investing was confused; analysts got forecasts completely wrong and even commodities failed to perform to the level many city analysts had anticipated.

    Generally speaking traditional investment banking was weak (bar advisory work and ECM/DCM book-running), while loan-origination remained abysmal.

    Nonetheless, profits at banks and financial institutions flowed forth. So just just where did the money come from?

    The obvious answer, by and large, would be prop trading desks. But to what extent did market-making strategies play a part in delivering profits? The one thing the crisis brought, after all, was a general expectation that wide bid/ask spreads were generally justified.

    And the three things market-makers really need: customer flow, wide spreads and volatility. Directional views, meanwhile, are not really their business.

    But that’s not all of it. The strategy that may have really helped big banks up the ante on smaller independent market-makers is ‘internalization’ - the process of matching orders internally with proprietary ’systematic internalizer’ models.

    As Investopedia explains:

    What Does Internalization Mean? A decision by a brokerage to fill an order with the firm’s own inventory of stock.

    When a brokerage receives an order they have numerous choices as to how it should be filled. They can send it to an exchange, an ECN, market maker, a regional exchange or fill it by using the firm’s own inventory of stock. Firms often internalize orders when they can because they profit from the spread.

    The bigger the bank, the more inventory it presumably has; the more inventory, the easier to profit from the spread.

    But why would banks be internalizing flow more than ever now? The easy answer is that technology has helped banks improve their risk management. Furthermore, there have been some significant regulatory changes — like the enactment of the MiFID directive in Europe — which have largely helped legitimize the practice.

    For example, MiFID now rules the practice is completely acceptable as long as ’systematic internalizers’ provide best execution by publishing firm buy and sell prices that are reflective of the market.

    Still, it remains a controversial issue, for two main reasons:

    A) it’s very hard to estimate how much flow is being internalized at any given time and hence how much money banks are making from the practice and B) because the definition of ‘best execution’ remains pretty fuzzy.

    An article in the American Thinker by Jeffrey R. Carter recently opined on the matter as follows:

    Internalization of order flow is another unseemly practice the SEC allows. Investment banks use their own customer orders and send them to a proprietary trading desk away from an exchange. Prop desks take the opposite side of those orders and make a risk-free profit. The customer order never sees the light of day. If the prop desk can’t make a profit from the order, it routes the order to an exchange.

    And as Wall Street & Technology commented in an article about internalization back in 2005:

    The reason that internalization is such a contentious topic is the obvious conflicts of interest inherent in the practice. As a broker, the firm has a fiduciary responsibility to obtain the best possible execution for its clients. However, as a dealer trading against the firm’s own clients, there is strong incentive to give clients the worst prices possible while conforming to existing – and rather vague – rules on execution quality.

    Meanwhile, another market development that would have helped banks boost internalization profits has been the continued growth of bank-backed or bank-issued ETFs. These funds provide fund-issuer banks with continuously changing demands as well a massive inventory of stocks and assets to match orders against.

  2. All i know, is for this year, liquidity especially for small mid caps has been an absolute disaster.:mad:
  3. aka.....accomodative trading, uncompetitive trading, commiting acts detrimental to the well-being of the customer, front running......:cool: