Costs and benefits of trading with stock dealers: The case of systematic internalizers

• Published date: 01 June 2024
• Author: Fatemeh Aramian,Lars L. Nordén
• Date: 01 June 2024
• DOI: http://doi.org/10.1111/eufm.12430

DOI: 10.1111/eufm.12430

ORIGINAL ARTICLE

Costs and benefits of trading with stock

dealers: The case of systematic internalizers

Fatemeh Aramian

1

|Lars L. Nordén

2

1

Department of Finance, University of

Melbourne, Parkville, Melbourne,

Australia

2

Stockholm Business School, Finance

division, Stockholm University,

Stockholm, Sweden

Correspondence

Fatemeh Aramian, Department of

Finance, University of Melbourne,

Parkville 3010, Melbourne, Australia.

Email: fatemeh.aramian@unimelb.

edu.au

Abstract

Systematic internalizers are single‐dealer platforms run

by investment firms that trade out of their own

inventories by internalizing the trades off exchanges.

We analyze the determinants of dealers' market shares

and trading costs. We find that dealer trades have

lower price impacts than exchange trades, consistent

with uninformed traders seeking out dealers. Due to

their ability to avoid trading with informed investors,

dealers often undercut the exchange bid–ask spread

when the spread is wide and the tick size is not

binding. Dealers can therefore offer lower trading costs

and gain a higher market share relative to exchanges.

KEYWORDS

dealers, equity markets, exchanges, systematic internalizers,

trading costs

JEL CLASSIFICATION

G10, G14, G15

Eur Financ Manag. 2024;30:1094–1124.1094

|

wileyonlinelibrary.com/journal/eufm

EUROPEAN

FINANCIAL MANAGEMENT

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. European Financial Management published by John Wiley & Sons Ltd.

We thank Jan Wallander and Tom Hedelius Foundation and the Tore Browaldh Foundation for research support. We

thank John Doukas (Editor), Björn Hagströmer, Pablo Landherr, Lu Liu, Christian Neumeier, Gunther Wuyts, and an

anonymous referee for useful discussions and suggestions. We also thank participants at the 2019 CEPR‐Imperial‐Plato

Market Innovator (MI3) Conference on Market Structure in Europe and Beyond, the Eighth National PhD Workshop in

Finance, and the EFMA 2021 Conference for valuable input.

1|INTRODUCTION

The traditional organization of equity markets used to be a trading floor in a centrally located

stock exchange building. In that market structure, the main liquidity suppliers were dealers,

who were physically present on the trading floor, trading out of their own inventories. Today,

equity markets are electronic and fragmented across exchanges, dark pools, crossing networks

and single‐dealer platforms, with different costs and market structure for each trading venue

(O'Hara, 2015). In this market setting, traders supply and demand liquidity on an electronic

multiple‐venue trading floor.

Trading venues adopt their own optimal market structure and strategy, and their choice of

optimal market structure influences traders and the way they participate in the market

(O'Hara, 2007). The coexistence of dealers and exchanges provides opportunities for traders to

choose venues based on their trading needs. Lower pretrade transparency and the possibility of

individual negotiation make dealer platforms potentially attractive to traders who want to limit

the exposure of their trading intentions. Others, particularly investors who trade on

information or trade in small sizes, might prefer the anonymity and high transparency offered

by exchanges. Generally, traders seek to minimize their trading costs by optimally choosing the

venue that matches their trading needs in terms of transparency and anonymity (Harris, 1993).

What are the determining factors in traders' selection between dealers and exchanges? What

determines the costs to trade on dealer platforms? In the current electronic market setting, are

informed or uninformed traders seeking out dealers? We investigate these research questions in

the European equity market, where recent regulatory reforms highlight the competition

between exchanges and single‐dealer platforms. Our focus is on trading costs and information.

In our analyses, we follow Glosten (1987), among others, and measure trading costs with the

effective spread and the information content of trades with the price impact component of the

effective spread.

Regulators try to keep up with equity market innovation and to initiate the way for

development. In Europe, the Markets in Financial Instruments Directive (MiFID) in 2007

allowed for competition between traditional exchanges, multilateral trading facilities (MTFs),

dark pools, and systematic internalizers (SIs).

1

SIs are single‐dealer platforms run by

investment firms and registered by the European Securities and Markets Authority (ESMA)

that deal through their own accounts when executing orders outside exchanges. Regulators

followed up with MiFID II in 2018, with the intention of reducing fragmentation and

improving the transparency of equity trading. The implementation of MiFID II boosted SIs'

market share of trading in European equity markets from 2% in 2017 to 20% in 2018, according

to ESMA.

Public equity exchanges used to operate as dealer markets where a group of dealers would

trade under the rules and regulations of the exchanges. With the introduction of electronic

trading, most exchanges moved from operating as a dealer market to a limit order book market.

Today, trading in dealer markets is mainly conducted off exchange, where trading is less

transparent and regulated. The promotion of single‐dealer platforms as qualified trading

platforms by MiFID II highlights the role of dealers in equity markets. Hence, it is essential to

1

In the United States, also in 2007, the Regulation National Market System brought about similar changes. MTFs are lit

trading venues facilitating the trading of different securities among multiple parties. Henceforth, we refer to traditional

stock exchanges and MTFs simply as exchanges.

ARAMIAN and NORDÉN EUROPEAN

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