Preferencing, Internalization, Best Execution and Dealer Profits

The practices of preferencing, internalization, and best execution have been criticized as causing worse execution in dealership markets like NASDAQ relative to auction style markets like the NYSE. We study the quality of executions and the profitability of market making for internalized, preferenced and non-preferenced order flow on the London Stock Exchange for the FTSE-100 stocks (these are the most liquid stocks on the exchange). Our data allow us to identify the broker who initiates and the market maker who executes each trade. Our results indicate that order flow executed by market makers not posting the best quotes (preferenced order flow) receives worse execution relative to non-preferenced order flow while the order flow routed by a broker to a dealer belonging to the same firm (internalized order flow) receives better execution compared to the rest of the order flow. Although preferenced order flow is associated with higher spreads, dealers executing a larger proportion of preferenced order flow do not seem to be make significantly higher trading profits. In addition, we find that the dealers make overall profits that are not statistically different from zero. These results are contrary to the predictions of the `collusion' hypothesis and the `quotes are free options' hypothesis. However, they are consistent with the hypothesis that there are costs of negotiating quotes and that customers have relationships with dealers. We also find evidence that dealers make money on small and large trades but lose money on medium sized trades which is consistent with the `stealth trading' hypothesis. Finally, cross-sectionally in our sample, we do not find any relationship between either the inside spread or the effective spread in a stock and the extent of preferencing or internalization in that stock