the trade is a sale:Estimated Cost = TradeSize × TradeSign × (TradePrice − BenchmarkPrice )
©2002 Oxford University Press
Draft: March 5, 2002
21-3
Professor Larry Harris
Trading and Exchanges
Draft Copy
Chapter 22Performance Evaluation and PredictionMany people trade because they want to speculate successfully. They hope to profit by buyingsecurities and contracts that will rise in value and by selling those that will fall.Unfortunately for those of us who would like to get rich quickly, predicting future prices is quitedifficult. Some people can do it, but most cannot. Successful speculators must predict futureprices well enough to beat the market on average. Unsuccessful speculators eventually losemoney when trading. At best, they make less money than they would have made had theysimply bought and held index funds. If they trade only because they want to earn speculativetrading profits, they should stop trading.In this chapter, we consider how to measure past performance and how to predict futureperformance. The two questions are closely related. Most people measure past performanceprimarily because they want to predict future performance. We shall see why predictions basedonly on past performance generally are quite unreliable. We can predict performance betterusing other information.You must be able to predict performance if you intend to speculate. Speculators trade onlybecause they expect to profit. Successful speculators therefore must constantly consider whethertheir trades will be profitable. If you cannot predict whether you will trade profitably, youshould not speculate. The most important decision speculators make is whether they shouldtrade.You also must be able to predict performance if you employ active investment managers tospeculate on your behalf. Active investment managers speculate with their clients’ money. Theyare active, as opposed to passive, because they actively try to identify and exploit speculativeopportunities. Accordingly, they often trade frequently. You can hire their services byemploying them as investment advisors or you can obtain their services indirectly by buying themutual funds and commodity pools that they manage. In either event, when managers speculateon your behalf, you speculate on their success. To select good active investment managers, youmust predict which ones will speculate successfully. If you cannot predict which managers willbe successful, you should not employ active investment managers. The most important decisioninvestment sponsors make is whether to employ active managers.Investors who believe that they cannot speculate successfully often invest their money withpassive investment managers. Passive investment managers use buy and hold strategies. Theysimply buy and hold securities. Passive managers therefore rarely trade. The most common buyand hold strategy is the index replication strategy. Index replicators buy and hold portfolios thatthey design to replicate the returns to a broad market index. We discuss how they do this in thenext chapter (Index Markets).Indexing is very popular because many investors have decided that they do not want to speculate.They do not believe that they would be successful traders, and they do not believe that they canpick successful managers. The limitations of performance evaluation and prediction help explainwhy index markets are so popular.
©2002 Oxford University Press
Draft: March 5, 2002
22-1
Professor Larry Harris
Trading and Exchanges
Draft Copy
People often design investment management contracts so that the payments that investmentmanagers receive depend on the performance they produce. Such contracts encourageinvestment managers to better serve their clients. You must appreciate the limitations ofperformance evaluation to understand how to best compensate investment managers and tounderstand the problems that arise in typical investment management contracts.Our discussion begins with a discussion of the principal problem of discriminating between skilland luck. We then briefly consider the mechanics of performance evaluation. If you alreadyknow how analysts compute returns, and how and why they compare them to benchmark returns,you can skip this section. The discussion then turns to the problem of predicting performance.We consider first how statisticians approach the problem and explain why their approach is notvery powerful. We then will consider alternative approaches to performance prediction based oneconomic theory.By the end of this chapter, you will understand why past performance does not necessarilypredict future returns. You will also understand how sample selection biases affect theinferences you may make about investment decisions. Failures to understand these issuesprobably account for more trading losses than any other mistakes traders make.22.1 The Performance Evaluation ProblemPortfolio performance depends partly on the quality of its management. Managers that performwell add value to their portfolios. Managers that perform poorly waste value.
Portfolio performance also depends on every factor that determines the values of the instrumentsin the portfolio. The factors may include macroeconomic, microeconomic, and firm-specificfactors. Macroeconomic factors include changes in interest rates, general economic activity,productivity, and exchange rates. Microeconomic factors include industry supply and demandconditions, technological innovations, and government interventions. Firm-specific factorsinclude a host of issues ranging from whether the firm is well managed to whether factories burnaccidentally down to whether researchers make fortuitous discoveries.Active managers try to foresee every factor that will affect values. They then buy thoseinstruments that they expect will appreciate and sell those that they expect will depreciate. Ifthey are very skilled, they will be able to add substantial value to their portfolios by selectingwhich instruments to buy and which to sell.No one can anticipate most factors that affect portfolio returns. Unforeseeable factors thereforehave a seemingly random effect on performance. Portfolios that perform well may be managedby skilled managers or by lucky managers. Likewise, poor performing portfolios may bemanaged by unskilled managers or by unlucky managers.Sizzler Sick with E. Coli
Sizzler International is an operator/franchiser of family restaurants that specialize in grilledmeats. Sizzler operates 65 company stores in the United States, and it franchises another 200stores. In 1998, the company reorganized in a voluntary Chapter 11 bankruptcy. By the middleof 2000, its earnings were accelerating and many analysts, who had carefully studied thecompany and its future prospects, believed that it had a winning strategy for revitalizing the
©2002 Oxford University Press
Draft: March 5, 2002
22-2
Professor Larry Harris
Trading and Exchanges
Draft Copy
chain. Based on their research, many investment managers bought Sizzler expecting that itwould outperform the market.They did not realize their expectations. In July 2000, the bacterium E. Coli infected 42 patronsof a Milwaukee Sizzler franchise. Seventeen were hospitalized and a three year-old girl diedfrom complications resulting from the infection.Eating undercooked meats, or food contaminated by raw meat, spreads the E. Coli infection.The Milwaukee Health Commissioner believed that eating contaminated watermelon spread theinfection.News about the outbreak was well publicized throughout the country. Following theannouncement, Sizzler’s stock fell 35 percent as investors feared the lawsuits and the lostreputation that would surely follow this tragic event.The speculators who bought Sizzler may have been very well informed about its futureprospects. They undoubtedly knew that food poisoning episodes occasionally plague restaurantchains, and they probably discounted Sizzler’s stock—and those of other restaurant chains—accordingly. Some even may have considered whether Sizzler designed and implementedadequate sanitary procedures to appropriately control the risks that they faced. Despite all theseconsiderations, the Sizzler E. Coli food poisoning episode probably was not predictable. Theseinvestors were simply unlucky.The investment policies that govern many portfolios often have a substantial effect on portfolioperformance. These policies may prohibit skilled managers from exploiting positive factors orfrom avoiding negative factors. They also may force unskilled managers to unknowingly exploitpositive factors or avoid negative factors. Portfolios that perform well therefore may bemanaged by skilled managers or simply by lucky managers subject to investment policies thatthe market currently favors. Likewise, poor performing portfolios may be managed by unskilledmanagers or by skilled managers subject to investment policies that currently are out of favor.For example, consider the performance of portfolios that must be fully invested in equity. Theseportfolios fluctuate in value with the market regardless of how management operates. When themarket rises, even the worst managed portfolios may have high positive returns. A market risecan offset losses due to inept management. Likewise, when the market falls, the best-managedportfolios may have negative returns. A market fall can overwhelm gains due to superiormanagement.Unforeseeable factors and unavoidable factors greatly complicate the performance evaluationproblem. These factors make it difficult to estimate the manager’s contribution to portfolioperformance. Good performance evaluations must discriminate between skill and luck. Analystsmust break total performance into separate components representing the contribution due tomanagement and the contribution due to factors that no one could anticipate or control.The task of estimating the contribution of factors that no one could anticipate or control is verydifficult because so many factors affect portfolio returns. Even the best estimates of managerperformance are quite noisy. Discriminating between skill and luck as explanations for portfolioperformance is very difficult.
©2002 Oxford University Press
Draft: March 5, 2002
22-3
Professor Larry Harris
Trading and Exchanges
Draft Copy
Part VIIMarket StructuresThe final chapters of this book examine the economics of market structures. The topics weconsider encompass many active regulatory debates.In Chapter 23, we consider why index markets are organized as they are. Our discussion showshow uninformed traders benefit from trading indexes.Chapter 24 examines the specialist trading system. Specialists are broker-dealers who supplyliquidity and arrange trades at exchanges and at some proprietary trading firms. Exchanges,regulators, and their business models sometimes compel specialists to supply liquidity when theyotherwise would not want to do so. To encourage them to offer such liquidity, they must receivesome benefit from their unique positions.The next three chapters examine how markets and dealers compete against each other for orderflow. We examine internalization and order preferencing by dealers in Chapter 25, why marketsconsolidate and fragment in Chapter 26, and screen versus floor based trading in Chapter 27. Wepay special attention to the problems that result when traders can trade the same instruments indifferent places.Chapter 28 discusses the origins of extreme volatility. There we consider how market structurescontribute to—and mitigate—volatility. We also consider whether markets should have circuitbreakers to control excess volatility.Chapter 29 considers the benefits and consequences of prohibiting insider trading. Interestingly,the most important issues involve labor economics rather than market microstructure.
©2002 Oxford University Press
Draft: March 5, 2002
Professor Larry Harris
Trading and Exchanges
Draft Copy
Chapter 23Index and Portfolio MarketsIndex trading is one of the most important financial innovations of the twentieth century. Thenominal dollar value of trading in equity index products now is greater than the total dollar valueof trading in the underlying securities. The growth of index trading has had a profound effect onequity markets. It is also increasingly affecting debt markets.Index markets trade index products. Index products include index futures contracts, indexoptions contracts, and securities that represent ownership in index funds. Index funds areportfolios that their managers design to replicate the performance of various price indexes. Mostindex funds track market equity indexes. Some funds also track debt indexes and sector equityindexes.Index products and index markets are extremely popular. Many people have decided that theywould rather invest in an index product than risk losing money investing with an activeinvestment manager. Index products also are attractive to speculators who want to speculateonly on index risks or only on firm-specific risks. The former buy or sell index products toestablish their speculative positions. The latter sell or buy index products to hedge the index riskin their long or short positions in individual securities.The widespread use of index strategies has changed the character of markets. Index markets arefar more liquid than the underlying cash markets upon which their products are based. Pricechanges in index products generally lead changes in the cash index. Consequently, many peoplebelieve that index markets are the “tail that wags the dog.” You must understand index strategiesto understand the relation between index markets and their underlying cash markets.In this chapter, we will briefly consider how indexes are computed, and how index funds aremanaged. We then will consider why index products and index markets are so popular. Youmay find this section particularly useful if you are unsure of whether you should invest orspeculate in equities. The chapter closes with a discussion of the various ways that tradersexchange index risks.23.1 Price IndexesPeople use price indexes to characterize the values of lists of instruments. The instruments uponwhich a price index is based are the index components. The index components determine thecharacter of the index. Indexes exist for entire markets, for subsets of a market, and for sets ofmarkets. The instruments may be equities, debt securities, commodities, or currencies. Indexesthat only include a small subset of market securities are narrow indexes. Narrow indexes havebeen defined for small and large securities, value and growth securities, industry sectorsecurities, and securities of firms that do business in narrow geographic regions.
Most price indexes are proprietary products that exchanges, brokers, or data vendors compute.Although index creators sometimes sell their indexes, they also often offer them to their clientsto promote their businesses. Many index creators also license their indexes to firms that baseindex products upon them.
©2002 Oxford University Press
Draft: March 1, 2002
23-1
Professor Larry Harris
Trading and Exchanges
Draft Copy
All price indexes are essentially just averages of the prices of their index components. Indexesdiffer by the methods used to compute those averages. The two most common index types areprice-weighted and value-weighted indexes.A price-weighted index is proportional to the sum of the prices of the index components. Thehighest priced instruments therefore have the greatest influence over the values of price-weightedindexes. The Dow Jones Industrial Average (DJIA) and the Nikkei 225 Stock Average are thebest-known price-weighted indexes.The Major Market Index and The Major Market Index
Dow Jones and Co. owns the Dow Jones Industrial Average (DJIA), which is a price-weightedindex of 30 large US stocks. The list originally included only industrial stocks. It now includessome stocks in the finance and services sectors of the economy. The Dow 30 is the best-knownUS market index. It is the major market index.For many years, Dow Jones refused to license the DJIA to options and futures exchanges thatwanted to create contracts based upon it. The American Stock Exchange therefore created anindex called the Major Market Index (MMI). The MMI is a price-weighted index of 20 blue chipstocks. Not coincidentally, most of the stock MMI stocks are also Dow 30 stocks. Changes inthe MMI therefore are very closely correlated with changes in the DJIA. The American StockExchange trades options on the MMI using the ticker symbol XMI. They also licensed the indexto the Chicago Mercantile Exchange, which traded futures on it.In 1997, Dow Jones finally licensed the DJIA to the Chicago Board of Trade (CBOT) and to theChicago Board Options Exchange (CBOE). The CBOT Dow Jones Industrials futures and theCBOE Dow Jones Industrials options contracts have been very successful. Both have killed theirrespective MMI competitors. The CME stopped trading their MMI contract in 1999. Althoughthe AMEX MMI options contract continues to trade (as of December 2001), it no longer hassignificant open interest.A value-weighted index is proportional to the total capital value of all index components.Traders therefore also call value-weighted indexes capitalization-weighted indexes. Securitieswith the highest capital value have the greatest influence over the values of value-weightedindexes. Most price indexes are value-weighted indexes. The S&P 500 Index is the best-knownvalue-weighted index.The value of an index is obtained by dividing the price or value sum by a constant index divisor.The divisor originally was a number that the index creator chose to ensure that the index startedat an arbitrary initial value. Divisors now change only when necessary to ensure that the value ofan index does not change when the creator adds or deletes index components, or, in the case of aprice-weighted index, when a stock splits. For example, the divisor of a price-weighted indexmust increase when a high priced stock replaces a low priced stock. Otherwise, the changewould unnaturally increase the value of the index. Likewise, the divisor of a value-weightedindex must increase when a high capitalization stock replaces a low capitalization stock. Thedivisors of value-weighted indexes do not have to change when stocks split because splits do notchange total capital values.You may occasionally encounter equal-weighted and geometrically weighted indexes. Equalweighted indexes measure the returns from investing an equal dollar amount in each index©2002 Oxford University Press
Draft: March 1, 2002
23-2
Professor Larry Harris
Trading and Exchanges
Draft Copy
component. The index values represent the cumulative returns to this hypothetical investmentstrategy. The best-known equal-weighted index is the CRSP (Center for Research in SecurityPrices) equal-weighted market index. It is used primarily in academic research. Geometricallyweighted indexes average logarithmic returns rather than prices. The Value-Line GeometricIndex is a value-weighted index of logarithmic returns.A price index is dividend-adjusted if it is adjusted upwards when securities pay dividends.Traders also call dividend-adjusted indexes total return indexes because they measure the totalreturn—capital gains plus income yield—that investors would receive if they could invest in theindex without any transaction costs. People generally use total return indexes as benchmarksagainst which they measure the performance of their portfolios. The DJIA and the S&P 500Index are not dividend-adjusted indexes. Corresponding total return indexes for these twoindexes, however, are widely available.23.2 Index FundsAn index fund is a portfolio that index managers design to replicate the performance of an index.Tracking error is the difference between the portfolio return and the corresponding dividendadjusted index return. Index fund managers try to minimize their tracking errors. Most USindex funds try to replicate the S&P 500 Index, although other indexes are becomingincreasingly popular.They Each Manage about 3 Percent of All World Equity
Barclays Global Investors is the world’s largest index fund manager. As of December 2000, thefirm had 571 billion dollars under management in various US and international equity indexfunds. (The firm had 802 billion dollars of assets under management counting all asset classes.)By comparison, total world traded equity market capitalization was then approximately 31trillion dollars. Counting only index funds, Barclays Global Investors manages a bit less than 2percent of all traded equity in the world.The world’s largest equity manager is Deutsche Asset Management which manages about 1trillion dollars worldwide in many subsidiaries.Sources: http://www.barclaysglobal.com/about/who_we_are/assets_rankings.jhtml;http://www.fibv.com/publications/Ta1300.pdf
Replicating a value-weighted equity index is quite simple. If the value of the index fund is 0.01percent of the total capitalization of all the index components, the index fund manager simplybuys 0.01 percent of the outstanding shares of each index component. The value of the fundtherefore is exactly proportional to the total value of all index components, which is proportionalto the value of the value-weighted index. Consequently, percentage changes in these threequantities will be identical. Index managers must rebalance a value-weighted portfolio onlywhen the list of index components changes. Otherwise, the fund simply holds its securities.Replicating a price-weighted equity index is equally simple. The index fund simply holds anequal number of shares in each index component. The value of the portfolio therefore isproportional to the sum of the prices of the index components, which is proportional to the priceweighted index. Percentage changes in these three quantities therefore will be identical. Index
©2002 Oxford University Press
Draft: March 1, 2002
23-3
Professor Larry Harris
Trading and Exchanges
Draft Copy
Chapter 24SpecialistsSome exchanges assign special responsibilities to members they designate as specialists. Thespecialists must continuously quote two-sided markets so that markets always exist in theirspecialties. They must also ensure that their markets are orderly and that prices do not jump tooquickly.Exchanges that designate specialists have designated primary market maker trading systems, ormore simply, specialist trading systems. The largest equity exchange that designates specialistsis the New York Stock Exchange.Exchanges with specialist trading systems believe that their specialists enhance market qualityand thereby attract traders to their exchanges. They believe that continuous and orderly marketsincrease investor confidence so that investors are more willing to invest in the exchanges’ listedcompanies. By attracting investor interest, these exchanges encourage issuers to list theirsecurities with them. The exchanges thereby obtain greater revenues from listing fees andtransaction fees, and their members make greater profits as brokers and dealers.In this chapter, we describe the various obligations that exchanges impose upon their specialists.We show how these obligations often require that specialists trade when they do not want totrade and refrain from trading when they do want to trade. Specialist obligations therefore canbe quite costly to specialists. To encourage traders to accept these obligations, exchanges givespecialists various trading privileges. We describe these privileges and explain how specialistsprofit from them. To prevent abuses of these privileges, exchanges also impose restrictions onwhen specialists may trade.Although all traders appreciate the liquidity that exchanges obligate their specialists to provide,many traders resent that they have special privileges. The special privileges can be quitevaluable to specialists and hence costly to other traders. The specialist trading system thereforeis the subject of regulatory controversy. Regulators must consider whether the value thatspecialists obtain from their privileges is commensurate with the value of the services that theyprovide. The traders who benefit when specialists fulfill their obligations usually are not thesame traders who are hurt when specialists exercise their privileges. Regulators therefore alsomust consider whether the resulting transfers of wealth among traders are appropriate.You must understand the specialist trading system if you trade at exchanges that employ suchsystems. At such exchanges, the execution of your orders will somehow involve specialists.They may act as your broker, they may act as dealers and fill your orders for their accounts, orthey may conduct the auctions in which brokers match your orders to other traders’ orders. Youwill make better trading decisions when you understand how specialists handle your orders.You also must understand the specialist trading system to understand how markets compete witheach other. The liquidity services that specialists offer are public goods in the sense thateveryone benefits from them. Unfortunately, public goods are hard to obtain in competitivemarkets. Few people will pay for them when they can freely obtain them. Regulators who valuethe liquidity that specialists offer must therefore carefully consider how markets compete witheach other. We introduce these issues at the end of this chapter and expand upon them when weconsider how markets compete with each other in Chapter 26.©2002 Oxford University Press
Draft: March 5, 2002
24-1
Professor Larry Harris
Trading and Exchanges
Draft Copy
Finally, you must understand the specialist trading system to responsibly consider whether floorbased exchanges that use specialist trading systems should convert to screen-based tradingsystems. Although exchanges can build a screen-based specialist trading system, many issuesmake such a structure unlikely. Analyses of conversions to screen-based trading thereforeshould consider the benefits lost and the costs saved if the specialist trading system werescrapped. This chapter will help you identify these benefits and costs.Specialist trading systems differ across exchanges. The distinguishing characteristic of thesesystems is that they impose obligations on dealers to supply liquidity. The obligations vary,however. Most exchanges restrict the trades that specialists can do, but some do not. Thischapter provides a general discussion of the principal economic and regulatory issues that arisein connection with all designated primary market maker trading systems. These issues arecommon to all variants of these systems. The examples that we will consider to illustrate theseprincipals, however, are specific to the specialist trading systems that the New York and theAmerican Stock Exchanges use.24.1 OverviewSpecialist trading systems are found primarily at US stock and options exchanges. Somemarkets in other countries also use them. The specialist trading system is most important at theNew York and American Stock Exchanges. The US regional stock exchanges also havespecialist trading systems, but most regional specialists are more like third market dealers thanprimary stock exchange specialists. The equity options markets organized by the Chicago BoardOptions Exchange (CBOE), the American Stock Exchange, the Pacific Exchange, and thePhiladelphia Stock Exchange also use specialist trading systems.
Specialists are known by different names in various markets. The CBOE calls its specialistsdesignated primary market makers. The Deutsche Börse calls its specialists designated sponsorsin English and betreuers in German. At the Paris Bourse, they are known as animateurs.Third market dealers also often call their traders specialists. The business models of these firmsoften obligate their traders to offer liquidity when they otherwise might not want to do so. Theseobligations are voluntary, however. The dealers propose and accept them as conditions forobtaining order flow from brokers. The NASD, the SEC, and some court decisions restrict thetrades that these dual traders can do. These restrictions, however, usually are not as severe asthose that exchanges impose upon their specialists.Most specialists are dual traders who sometimes broker orders for their clients and other timesfill orders for their clients from their own inventories. Exchanges that permit dual tradinggenerally employ many regulatory safeguards to solve the resulting conflict of interest problemsintroduced in Chapter 7 (Brokers). Specialists therefore are subject to many regulations.Exchanges with specialist trading systems usually assign only one specialist to each stock oroptions class. We will discuss below how they make these assignments.Some exchanges use a designated multiple market maker trading system for trading theirsecurities. These systems are similar to specialist systems except that the exchanges obligatemultiple traders to offer liquidity that they otherwise might not want to offer. These obligationsare best enforced in electronic markets because traders in open outcry markets will hide when
©2002 Oxford University Press
Draft: March 5, 2002
24-2
Professor Larry Harris
Trading and Exchanges
Draft Copy
they do not want to trade. When nobody wants to trade, a computer usually assigns theobligation to trade in rotation to each of the designated market makers.The CBOE uses a designated multiple market maker trading system for its most actively tradedindex options series. Unlike most specialists, their designated market makers are not dualtraders. They deal only for their account, and they do not broker agency orders. Like specialists,the market makers have some obligations to provide liquidity when markets are not tradingnormally. Similar structures appear at some European options exchanges and at some futuresexchanges.The number of stocks or option classes that each specialist trades depends on how actively tradedthe instruments are. Specialists who specialize in very actively traded securities usually tradeonly one security or options class. Those who specialize in less frequently traded securities tradelarger lists. Most specialists trade only a few securities. For example, most of the 482 individualspecialists at the New York Stock Exchange trade between three and six stocks each. Theyusually have one actively traded security and a few less actively traded ones.Most specialists work for firms that employ many specialists. In December 2001, only eightfirms employed all specialists at the NYSE. Five of these firms handled stocks representing 95percent of all the NYSE dollar volume.Specialists play three roles in most markets. They are dealers when they trade for their ownaccount. They are brokers when they broker orders and trades for other brokers. Finally, theyare exchange officials who are responsible for conducting orderly markets. We consider thesethree main roles in the next three sections.24.2 Specialists as DealersSpecialists act as dealers when they trade for their own accounts. Exchanges greatly regulate thetrading that specialists can and must do for their own accounts.
Two sets of regulations govern specialist trading. Affirmative obligations obligate specialists tooffer liquidity in various circumstances. Negative obligations prevent them from trading in othercircumstances. Specialists accept these obligations because they enjoy the various privileges thatcome with them.24.2.1 Affirmative ObligationsThe specialists’ primary affirmative obligation is to ensure that a reasonable market alwaysexists in their specialties. When no one else is willing to trade, specialists must be willing totrade. They must quote two-sided markets when no one else will, and their quotes must bemeaningful in the sense that the spread between the best bid and the best offer cannot be toowide. Since specialists must often trade when no one else is willing to trade, they are often thetraders of last resort.
Their obligation to make markets is limited, however. Specialists do not have to make firmquotes for large block sizes, and they are not required to support prices when values are falling orrestrain prices when values are rising. They simply have to ensure that public traders can alwaystrade some meaningful quantity.
©2002 Oxford University Press
Draft: March 5, 2002
24-3
Professor Larry Harris
Trading and Exchanges
Draft Copy
Chapter 25Internalization, Preferencing, and CrossingDealers internalize orders when they fill their clients’ orders. Brokers preference orders whenthey route their clients’ marketable orders to dealers in exchange for various monetary ornonpecuniary payments for order flow. Brokers also preference when they route their clients’limit orders to electronic communications networks (ECNs) that pay them liquidity fees whenstanding limit orders execute. Brokers cross orders internally when they arrange trades amongtheir clients.Internalization, order preferencing, and internal order crossing all arrange trades away fromorganized markets. Traders say that these practices fragment the markets.Internalization, preferencing, and crossing practices raise important regulatory questions. Mostnotably, clients and regulators wonder whether brokers who engage in these practices meet theirobligations to obtain best execution when filling their clients’ orders. Less obviously, tradersand regulators wonder whether these practices hurt markets by making it more difficult fortraders to find each other. All three practices decrease order transparency. Many people wonderwhether the markets would be better off with a single consolidated limit order book to whichbrokers would send all orders.In this short chapter, we discuss the issues that underlie these processes. We shall see thatinternalization and preferencing may benefit small market order traders. The practices generallyharm limit order traders, however. Internal order crossing tends to benefit crossing brokers andtheir clients at the expense of traders with whom the clients might have otherwise traded.Internalization, preferencing, and crossing affect all markets in which traders can trade awayfrom a central exchange. These practices have attracted the substantial attention in US equitymarkets. The attention undoubtedly comes from the high volumes traded in these markets, thehigh degree of transparency in these markets, and the ease with which traders and regulators cancompare dealer and public auction markets that simultaneously trade similar securities. Most ofthe discussion that appears in this chapter therefore draws on examples from US markets. Theforces that cause internalization, order preferencing, and internal order crossing, however, arepresent in all markets. If you understand how these forces work in US equity markets, you willbe able to identify them in all other markets.We start by discussing best execution and the effects of internalization and preferencing oncommissions. We then discuss the anticompetitive aspects of internalization and preferencing.The chapter ends with a short discussion about issues associated with internal order crossing.25.1 Best Execution PracticesBrokers who internalize and accept payments for order flow have a significant conflict of interestthat concerns clients and regulators. Brokers address these concerns by trying to provide bestexecution to their clients. Brokers provide best execution when they ensure that their clients