The next five years will see a considerable increase in order internalization as market pressures force firms to adopt the philosophy of liquidity management in order to stay competitive, a new research note from Westborough, Mass.-based TABB Group speculates. TABB Group defines liquidity management as the methodology firms use to automate their trading desks. This includes rules around pricing, algorithmic trading, direct market access, routing, internal crossing (dark pools), market making and proprietary trading.
Liquidity management methodologies are expected to rise to prominence in the near future as trading volumes continue to increase while broker-dealers try to maintain profitability with shrinking spreads and commissions. TABB Group expects firms to harvest the value of internal order flow by increasingly turning to internal crossing networks or dark pools to fill client orders while saving the firms the cost of sending an order to an exchange.
Regulation NMS and the Markets in Financial Instruments Directive (MiFID) will further encourage liquidity management by increasing reporting requirements for equity trades that use traditional internalization techniques, such as block trading and capital commitment. Managing this increase in internal liquidity, though, will require firms to put more-robust systems into place, the report says.
However, there should be a saturation point for the amount of potential internal order flow, TABB Group notes. At some point, the firm says, regulatory bodies will be obliged to step in to prevent brokers from internalizing too much order flow because the activity leads to uncertain pricing of securities, and imprecise and unclear reporting on daily execution volume in the markets. <<<