Is BEST really better? Internalization of orders in an open limit order book

This paper studies the market quality of an internalization system which is designed as part of an open limit order book (the Xetra system operated by Deutsche Börse AG). The internalization sys-tem (Xetra BEST) guarantees a price improvement over the inside spread in the Xetra order book. We develop a structural model of this unique dual market environment and show that, while adverse selection costs of internalized trades are significantly lower than those of regular order book trades, the realized spreads (the revenue earned by the suppliers of liquidity) is significantly larger. The cost savings of the internalizer are larger than the mandatory price improvement. This suggests that internalization can be profitable both for the customer and the internalizer.