Internalization, Preferencing, and Crossing: Alternative Trade Execution (Chapter 25)
Not every trade happens on an exchange. A lot of trading happens away from organized markets, and how it happens raises some genuinely difficult questions about whether investors are getting a fair deal.
Chapter 25 covers three practices that route orders away from central exchanges: internalization, preferencing, and internal order crossing. Larry Harris explains the economics behind each one, who benefits, and why regulators keep fighting about them.
The Three Practices
Internalization happens when dealers fill their own clients’ orders. Instead of sending your order to an exchange, your broker-dealer handles it internally.
Preferencing happens when brokers route their clients’ marketable orders to specific dealers in exchange for payments. This is the famous “payment for order flow.” Brokers can also preference limit orders to electronic communications networks (ECNs) that pay liquidity fees when those orders execute.
Internal order crossing happens when brokers match orders among their own clients, arranging trades without ever going to a public market.
All three practices fragment the market by arranging trades away from organized exchanges. And all three raise the same fundamental question: is the customer getting the best possible execution?
Best Execution: What Does It Even Mean?
Brokers who internalize or accept payment for order flow have an obvious conflict of interest. They’re choosing where to route your order based partly on what’s best for them, not just what’s best for you.
The industry response is the concept of “best execution.” Brokers claim they provide best execution when they ensure orders fill quickly at the best available prices.
But defining “best available prices” is tricky. For marketable orders, dealers typically claim best execution means filling at the national best bid or offer (NBBO), the best price quoted by any dealer or limit order trader anywhere. Some dealers guarantee NBBO execution up to a specified maximum size. Some markets even provide price improvement for small orders, executing them at slightly better prices than the NBBO.
For limit orders, best execution is even harder to define. Limit orders sit and wait. The question isn’t just what price they execute at (usually the limit price), but whether and when they execute at all.
The Economics: Follow the Money
Here’s where Harris gets really interesting. He argues that in perfectly competitive markets, internalization and payment for order flow don’t actually hurt retail traders on net. The logic goes like this:
Dealers compete to get wholesale order flow from brokers. If executing that order flow is profitable, dealers will pay more to get it. Brokers compete to get retail order flow from clients. If brokering is profitable, brokers will offer lower commissions and better services to attract customers. Competition drives excess profits to zero at both levels.
So if regulators demand that dealers provide better execution (tighter spreads, more price improvement), payments for order flow will fall. Brokers will have less money to subsidize commissions. Commissions will rise. In a perfectly competitive world, the net transaction cost (spread plus commission) stays the same regardless of how best execution is defined.
The trade-off is between visible costs (commissions) and hidden costs (bid-ask spreads). And this is the critical insight: retail traders pay more attention to commissions because they can see them. They can’t easily measure execution quality.
Harris explains it simply: “You cannot buy anything that you cannot measure.” If buyers can’t tell the difference between good and bad execution, suppliers have no incentive to provide good execution. They compete on the thing customers can measure (commissions) and let the thing they can’t measure (spreads) stay wide.
The brokerage industry actually prefers this arrangement. Low commissions encourage clients to trade more, generating more order flow. Wide spreads are hidden costs that most retail traders never notice or think about.
Why Spreads Are Wide
The orders that dealers and limit order traders don’t want are the ones that determine bid-ask spreads. Most brokers internalize or preference all the “good” orders (small, uninformed retail orders). What’s left, the orders that actually go to whoever offers the best prices, tends to be from larger, better-informed traders.
Dealers who offer firm quotes that anyone can take expose themselves to informed traders and to large traders who will force them into bad positions. So they quote wider spreads to compensate for these losses. Small uninformed traders end up paying these wider spreads even though they’re not the ones causing the problem.
Payment for order flow actually helps small traders in one specific way: when dealers can identify and separate uninformed orders (the “cream”), competition among dealers and brokers ensures those traders get lower commissions to offset the wider spreads. The cream skimming we discussed in the specialist chapter shows up here in the wholesale order flow market too.
The Anticompetitive Problem
But there’s a real cost to all of this. Internalization and preferencing weaken incentives for anyone to quote aggressive prices.
Think about it: if you post a great price on an exchange, but all the easy retail orders get routed to dealers who simply match your price, what’s the point of posting the aggressive quote? You take all the risk of displaying a firm price (informed traders can trade against you), but you don’t get much of the reward (order flow).
This is like a retailer who advertises “We’ll match any price in town!” It sounds competitive, but it actually kills the incentive for anyone to offer low prices in the first place. The retailers who offer the lowest prices don’t get rewarded with more customers.
Limit order traders in particular get squeezed. Internalization and preferencing reduce the chance that their limit orders will execute. The orders only execute when prices move toward them (which means they’re about to lose), and they don’t execute when prices move away (which means they would have profited). This adverse selection makes limit order strategies less attractive, shifting power from public limit order traders to dealers.
Internal Order Crossing
Crossing networks and block brokers match orders among their own clients. This usually provides good service: lower costs, larger size, and anonymity that clients can’t get elsewhere.
The regulatory concern is about order exposure. Brokers who cross internally only show orders to their own clients, not to the broader market. Since brokers want commissions from both sides, they’re reluctant to let other brokers participate. This makes it harder for natural buyers and sellers to find each other.
It’s exactly like real estate agents who show new listings exclusively to their own buyers before posting them publicly. The agent gets double commission but the seller might miss out on a higher offer from someone else’s client.
There’s also an agency problem. Brokers might favor some clients over others, arranging trades to benefit their preferred clients. Without market exposure, the harmed clients might never realize they got bad prices.
The Consolidated Limit Order Book Dream
Many people argued (and still argue) that all of this would be solved by a consolidated limit order book, a single market where all orders go to one place. No fragmentation, no cream skimming, no anticompetitive effects from preferencing.
Harris acknowledges the appeal but notes the trade-off: internal crossing and preferencing do provide real services that some traders value. Forcing all orders to a central market could destroy those services. And the more convoluted a competitive system is, the less efficient it tends to be.
The wholesale and retail order flow system is definitely more complex than a single centralized market. We can presume it’s less efficient. But “less efficient” for the system as a whole might still mean “better” for certain groups of traders, especially small uninformed ones who get lower commissions through the payment-for-order-flow pipeline.
The Uncomfortable Truth
Internalization and preferencing probably do provide better net prices (spread plus commission combined) to small uninformed traders. But they also weaken central markets, reduce incentives to display aggressive prices, and make it harder for buyers and sellers to find each other.
The total transaction costs of all buy-side traders are probably higher because of these practices. The benefits go to small retail traders and to the dealers and brokers who profit from handling their orders. The costs fall on limit order traders and on the market structure as a whole.
There’s no clean answer here. Every rule change helps some traders and hurts others. And that’s what makes market structure design so endlessly debatable.
Next: Competition Among Markets
This post is part of a series retelling “Trading and Exchanges: Market Microstructure for Practitioners” by Larry Harris (Oxford University Press, 2003). The goal is to make these concepts accessible to everyone, not just finance professionals.