Is Best Really Better? Internalization in Xetra Best

Xetra BEST, operated by Deutsche Borse AG as a part of the Xetra trading system, allows participating banks and brokers to internalize retail customer orders. This paper provides an empirical assessment of the market quality of Xetra BEST. For this purpose, we develop a trade indicator model of this dual market structure with an open order book and an internalization system that guarantees a mandatory price improvement over the inside spread of the book. We show that internalization is profitable, and that adverse selection costs of internalized trades are significantly lower than those of regular order book trades. However, the mandatory price improvement for internalized trades does not fully compensate for the difference in adverse selection costs. Our results imply that measures aimed at increasing competition among internalizers may yield improved execution quality for internalized orders