Internalization in European Equity Markets Following the Adoption of the EU MiFID Directive

Abstract

The European Union's Markets in Financial Instruments Directive (MiFID), that will be implemented by October 2007, significantly modifies the regulation of the European securities industry. It will allow, among other things, investment firms to act as systematic internalizers. A systematic internalizer is an investment firm dealing on its own account to execute client orders outside a regulated market or a multilateral trading facility (MTF). Specifically, the new regulation requires systematic internalizers to publish firm quotes on liquid shares when dealing for retail quantities. In short, systematic internalizers are market makers on liquid stocks who execute small trades. This article uses order flow and limit order book data in order to estimate the internalization rate (i.e., the portion of the total order flow that could be internalized), to estimate the internalization expected revenues, and to investigate the main factors affecting both the internalization rate and the magnitude of internalization revenues. Four main findings arise from our analysis. First, the internalization rate is negatively related to the stock turnover, that is more liquid stocks exhibit lower internalization rates. Second, the size and the variability of internalization trading revenues strongly depend on their composition. Third, spread revenues are highly concentrated in the most liquid stocks. Fourth, the value of the inventories for an average internalizer firm is limited relative to the stock turnover.