Could the Public Bid-Ask Spread Be Narrower in a Market without Internalization?

Concept

The question of whether public bid-ask spreads could narrow in a market devoid of internalization is a foundational inquiry into the very architecture of modern electronic markets. It probes the consequences of segmenting order flow, a practice that has become a structural norm. At its core, internalization is a routing decision. A broker-dealer, upon receiving a retail client’s order, chooses to fill that order from its own inventory rather than exposing it to the competitive crucible of the public exchanges.

This creates a bifurcated system where a substantial volume of trades, particularly from uninformed participants, never interacts with the central lit order books. The direct consequence is the alteration of the informational content of the order flow that public market makers observe.

This segmentation is predicated on a simple economic reality ▴ the predictable nature of most retail order flow. These orders are often uncorrelated with near-term price movements, making them low-risk to the counterparty. By internalizing this flow, dealers capture the bid-ask spread with minimal adverse selection risk. Adverse selection is the perennial hazard for market makers, representing the risk of trading with a counterparty who possesses superior information about a security’s future price.

When a significant volume of uninformed orders is siphoned away from the public market, the remaining flow on the lit exchanges becomes, by definition, more concentrated with potentially informed trades. Public market makers, facing a higher probability of transacting with sophisticated institutional participants, must adjust their risk parameters. Their primary tool for this adjustment is the bid-ask spread. A wider spread serves as a buffer, a premium charged to compensate for the elevated risk of being adversely selected.

The Division of Liquidity

Market structure is a system of interconnected liquidity pools. Internalization effectively creates private, opaque pools that run parallel to the public, transparent ones. The order flow within these private pools is homogenous ▴ largely uninformed retail trades.

The flow in the public pools becomes skewed towards institutional and algorithmic traders, whose activity may be driven by complex models and proprietary information. This dynamic challenges the principle of a central, unified market where all participants can compete on an equal footing.

Order Flow Composition and Risk

The composition of order flow is the primary determinant of a market maker’s quoting strategy. A market maker’s business model relies on earning the spread over a large number of trades while managing inventory risk. When the flow is balanced between buyers and sellers and contains a low percentage of informed traders, spreads can be kept tight. Competition between market makers ensures this.

However, the systematic removal of a specific type of low-risk order flow disrupts this equilibrium. The remaining public order flow presents a different risk profile, compelling a structural repricing of liquidity. This repricing manifests directly as wider public bid-ask spreads. The very act of separating uninformed orders from the consolidated market feed degrades the quality of that feed for public participants.

By siphoning off predictable retail order flow, internalization concentrates adverse selection risk in public markets, compelling market makers to widen spreads as a compensatory measure.

The public spread, therefore, becomes a reflection of a riskier environment. It is less an indicator of the true cost of intermediation for a balanced order flow and more a measure of the cost of intermediation in a market where a significant portion of the “easy” trades has been executed elsewhere. This raises critical questions about fairness and efficiency. While an internalized retail order may receive a marginally improved price compared to the displayed public quote, that public quote is itself wider than it might be in a fully unified market.

The system creates a feedback loop where the existence of internalization justifies the wider spreads that, in turn, make internalization appear to offer a superior execution price. The potential for a narrower spread in a non-internalized market remains a compelling theoretical endpoint.

Strategy

A strategic framework for achieving narrower public spreads involves reversing the market fragmentation caused by internalization. The central principle is the consolidation of all order flow onto transparent, competing lit venues. This approach is not about eliminating a participant class but about altering the architecture through which their orders interact.

By mandating that all orders, regardless of origin, are exposed to the full depth of the market, the informational asymmetry between public and private liquidity pools dissolves. This creates a single, more robust environment for price discovery, fundamentally altering the risk calculus for liquidity providers and fostering the conditions for tighter spreads.

The mechanics of this strategic shift hinge on reducing the adverse selection risk faced by public market makers. In a unified market, the “cream-skimmed” retail order flow would be reintegrated with the institutional and algorithmic flow. This blended order flow is statistically less risky for a market maker to trade against. The presence of a large volume of uninformed trades dilutes the concentration of informed trades, lowering the probability that any single transaction will result in a loss for the liquidity provider.

This diminished risk profile allows market makers to quote more aggressively. Competitive pressure, a constant in public markets, would then compel them to pass these risk-reduction benefits on to the market in the form of narrower bid-ask spreads. The spread would begin to reflect the true, blended risk of all market participants, rather than the heightened risk of a subset.

Comparative Market Dynamics

Analyzing the structural differences between a fragmented and a unified market reveals the pathways to spread compression. The incentives and behaviors of market participants shift in response to the quality and composition of the available order flow. A unified market structure aligns incentives towards on-exchange competition, which is the primary driver of tighter spreads and deeper liquidity.

The following table outlines the strategic shifts in market dynamics when moving from a system with internalization to one without it:

The Role of Competition

In a market without internalization, the primary venue for competition shifts. Broker-dealers who currently internalize would be compelled to compete for order flow on the lit exchanges. This could take the form of more aggressive market making, where they post tighter quotes to attract order flow, or by routing orders to the venues with the best prices. The result is a virtuous cycle ▴ the influx of all orders onto lit exchanges enhances liquidity and reduces risk, which in turn encourages more aggressive quoting.

This heightened competition is the engine of spread compression. The system’s efficiency increases as the cost of trading ▴ represented by the bid-ask spread ▴ is driven down toward its irreducible minimum, which is composed of processing costs and the baseline risk of intermediation in a fully transparent market.

Consolidating all order flow onto public exchanges would dilute the concentration of informed trades, reducing risk for market makers and fostering the competitive pressure needed to structurally narrow bid-ask spreads.

This strategic vision redefines best execution. Instead of price improvement against a potentially wide public quote, the goal becomes ensuring the public quote itself is as tight as possible. It is a shift from a localized, order-by-order optimization to a systemic optimization of the entire market’s structure for the benefit of all participants. The elimination of internalization would force a re-evaluation of how brokers serve their clients, moving from a model that profits from segmented flow to one that profits from facilitating access to the most competitive and efficient central market possible.

Execution

Executing a transition to a market structure without internalization requires a precise, mechanistic understanding of how order flow interacts with liquidity. The core operational principle is that the public bid-ask spread is a direct function of the perceived risk and competitive dynamics on the central limit order book (CLOB). By redirecting internalized order flow to the CLOB, we can model the direct impact on quote depth and market maker behavior. This is not merely a theoretical exercise; it is a quantitative exploration of how market architecture dictates execution quality.

Consider a hypothetical stock, “SYSTEMCORP,” trading in a market with significant internalization. We can model the state of its public order book and then simulate the changes that would occur if the internalized flow were instead routed to this public venue. This provides a tangible illustration of the forces that determine the spread. The key variables in this model are the volume and type of orders that are currently being withheld from the public book.

Quantitative Modeling of Spread Compression

The following analysis demonstrates the impact of reintegrating internalized order flow. We will examine two scenarios for SYSTEMCORP. Scenario A represents the current state with a high degree of internalization. Scenario B represents a market where all orders are routed to the public exchange.

Scenario a SYSTEMCORP Order Book with Internalization

In this scenario, a broker-dealer internalizes 10,000 shares of retail buy orders and 10,000 shares of retail sell orders. These orders are executed against the firm’s own inventory at the National Best Bid and Offer (NBBO). They never reach the public book. The public CLOB for SYSTEMCORP, therefore, reflects only the institutional and algorithmic interest, which is thinner and wider due to the heightened adverse selection concerns.

The public bid-ask spread in this scenario is $0.05 ($100.00 / $100.05). A large institutional order seeking to buy 5,000 shares would face this spread and potentially move the price as it consumes liquidity.

Scenario B SYSTEMCORP Order Book without Internalization

Now, let’s model the exact same market conditions, but under a rule that prohibits internalization. The 10,000 shares of retail buy orders and 10,000 shares of retail sell orders must be routed to the public exchange. Assuming these are primarily limit orders placed at or near the inside, they would dramatically augment the depth of the order book.

• The 10,000 retail buy orders are added to the bid side, increasing the size at each price level.
• The 10,000 retail sell orders are added to the ask side, increasing the size at each price level.

This influx of non-informed liquidity fundamentally changes the competitive landscape. Market makers, seeing a much deeper and more balanced book, can no longer justify a wide spread. The risk of being adversely selected on a small order is significantly lower.

Competition would force them to improve their quotes to interact with this new flow. A new, much tighter equilibrium would be established.

The resulting order book might look like this:

In this scenario, the public bid-ask spread has compressed to $0.01 ($100.02 / $100.03). The depth at the inside quote is also substantially larger. The reintegration of the retail order flow has created a more robust and competitive public market.

The narrower spread is a direct, quantifiable consequence of forcing all orders to interact and compete in a single venue. This operational shift moves the market from a fragmented state with artificially wide public spreads to a unified state where the spread reflects the true, lower risk of the entire order flow ecosystem.

Redirecting internalized orders to the public book adds substantial depth, forcing market makers to compete more aggressively and leading to a quantifiable compression of the bid-ask spread.

This model illustrates that the public spread is an output of market structure, not an immutable property of a security. A regulatory or structural change that re-consolidates order flow is a direct lever for influencing this output. The execution of such a strategy would involve phasing out off-exchange execution for retail orders, thereby ensuring that the benefits of this liquidity are socialized across the entire market, resulting in a narrower, more efficient public pricing mechanism for all participants.

Reflection

The Integrity of a Public Quote

The data and mechanics explored lead to a fundamental reflection on the nature of a public price quote. What does a bid-ask spread represent? In a fragmented system, it reflects a localized and incomplete reality ▴ the risk profile of only that portion of the order flow exposed to open competition. A market structure that permits widespread internalization implicitly accepts that the public quote will be wider than it otherwise could be.

The knowledge gained from this analysis should prompt a re-evaluation of one’s own operational framework. How does your execution protocol interact with this bifurcated liquidity? Are your routing decisions based on a public quote that is itself a product of market fragmentation? The ultimate pursuit of execution quality requires an understanding that the most critical data point ▴ the price itself ▴ is shaped by the architecture of the system that produces it. A superior operational edge comes from recognizing these structural dynamics and positioning to capitalize on a more unified, transparent, and competitive market landscape.