New Form of Internalization For Brokerage Firms
http://deepliquidity.com/broker_internalization.html
Deep Liquidity, an SEC licensed ECN, plans to launch a lit stock market with a minimum tick size of five cents as opposed to one cent in today’s markets. In specific response to brokerage firm’s needs to internalize order flow, Deep Liquidity has created a special order type (invented June 2011) that greatly expands brokerage firm’s ability to internalize orders. It basically allows brokerage firms to white label “rent out” Deep’s ECN for their own benefit for trades they want to cross internally. This is a big deal because Deep’s ECN will give brokerage firms the ability to put up trades at two cents above or below the NBBO and meet their best execution duty to their customers. These duel achievements in market structure will greatly enhance brokerage firms’ profits and more than offset any lost business if the SEC imposes the “Trade at Rule.”
This new form of internalization will allow brokerage firms to arbitrage the difference between the penny wide market and the nickel wide market. When a brokerage firm has an order that is smaller than the size offered in the Nickel ECN but larger in size offered at the penny wide markets (stock exchanges), it will be to the discretion of the brokerage firm at what price to internalize the order at, (the price offered at the Nickel ECN or the stock exchanges). If they internalize the order at the Nickel ECN price they will make “edge.” This is due to the reduced risk associated with filling an order that is smaller than what is offered in a competitively generated Nickel bid/offer spread. In other words, these orders in a true economic model would generate a market bid/offer spread somewhere between one and five cents. The difference in the theoretical spread is the “edge.”
This new form of internalization will be achieved by the introduction of a new type of limit order called “Preferenced Internalization.” This order type allows brokers to send Nickel ECN buy and sell orders they want executed at two cents above or below the NBBO using the Nickel ECN matching/routing engine against their private account with Nickel ECN.
This will allow brokerage firms to view Nickel ECN market from the sidelines, and enable brokers to internalize their orders based on price/size discovery generated in Nickel ECN. Brokers will NOT be required to trade against Nickel ECN’s top of book limit orders, but rather use Nickel ECN’s top of book for price/size discovery to establish a new “best execution” option that can be provided to their customers.
BENEFIT – It allows the broker or trading firm to earn a nickel spread on trades they fill with their own capital. It also allows them to trade ahead of Nickel ECN’s liquidity provider quotes, for orders they choose to internalize, and receive two cent edge, as opposed to a one cent spread when they take the other side of the trade of a customer’s order currently. They also will be afforded a valued view of market depth two cents above and below the NBBO in the Nickel ECN.
This new form of displayed market depth will be provided by the high frequency trading community. They will establishment “market prices” at two cents above or below the NBBO.
How It Works:
When a broker has a customer’s order that is larger than the shares displayed at the NBBO and one penny outside the NBBO, he can choose to send the order to Deep Nickel ECN for a two cent outside the NBBO execution provided the order is larger than the shares displayed at both two price levels.
Example:
XYZ Stock has 200 shares displayed at the national best bid price of $10.00 and 100 shares at $9.99. Nickel ECN has a bid quote for 2000 shares at $9.98.
Today’s Market for XYZ Stock Bid
200 $10.00
100 $9.99
Nickel ECN for XYZ Stock Bid
2000 $9.98 (Pegged at $.02 outside NBBO)
Market participants can grab the 300 shares at two price points ($10.00 and $9.99) or they can forgo those quotes or accept a single 2000 share Nickel ECN quote at $9.98. If Deep Nickel ECN receives a “Preference Internalization” order from a broker; it will cross and print the order at $9.98 against the broker’s account. Deep Nickel ECN will automatically send into the market sell orders to take any Reg. NMS protected quotes and credit those executions to the Broker’s account. The sitting 2000 buy quote in the Nickel ECN Book that provided the price/size discovery will be ignored.
