between a retail (protected) trade and an institutional one be? Is it not true that retail
investors sometimes make large trades and institutions small ones?
Perhaps, then, the distinction should be based on the assets and investment experience
of the investor. Again, this is a rather rough-and-ready means of distinction, but one which
is already used effectively in other circumstances. Certain securities in the US market are
considered inappropriate for retail investors, and those who wish to purchase them must
self-certify that they meet certain eligibility criteria (usually related to their primary busi-
ness or the assets they have under investment). The presumption is that investors are not
eligible for these risky investments unless they ``opt in'' through self-certification.
This approach helps us to understand how to make the distinction between retail and
institutional investors for best execution purposes. After all, it may be the case that a retail
investor wishes the trader to consider non-price factors either for one trade or for all trades.
The policy can start with the presumption that the trade is to receive retail protection ± that
is, retail best execution is the ``default'' standard. Investors could waive this protection and
opt in to institutional protection either on a one-time-only or a continuing basis.
This brings us to the end of a fairly lengthy logical chain, but one which is central to
making best execution work. Best execution needs to encompass all price factors, but non-
price factors may be more important for some investors, some or all of the time. These
investors should be accommodated with a separate, appropriately broad standard, but
those retail investors most in need of protection must be afforded the protection of tighter,
net-price-based standards. These retail standards should be presumed to be in effect for all
retail investors, but any investor could waive retail protection and opt in to the broader
standard either as needed or on an until-revoked basis.
3.12 Other issues
3.12.1 Internalisation
The practice of ``internalising'' orders was the focus of considerable debate in the course of
the European Commission's review of the Investment Services Directive begun in 2001 and
has been a topic of debate in the United States for some years. Internalisation, simply put,
occurs when a firm executes incoming customer orders ``internally'' either against other
customer orders or against its own account. They therefore do not execute on any exchange,
though their execution may be reported to an exchange afterwards.
Internalisation can be beneficial to the retail customer in some circumstances. Intern-
alised orders do not require certain operational services, potentially reducing the cost of the
trade (assuming that the lower cost is passed on to the customer). The magnitude of this
saving varies, however, since the fees associated with trading on some exchanges are
considerably lower than on others. Orders could also potentially receive faster execution
in-house, though again the impact would vary and is likely to diminish as technologies to
route orders to exchanges become more and more advanced.
The implications for best execution are twofold. First, is an internalised order isolated
from the wider market, depriving it of potentially better execution outside the internalising
firm? In other words, how is the best price defined for internalised orders ± the best price
amongst those with which it interacts (other internalised orders and the firm's own pos-
itions), or the best price in the market as a whole?
Chapter 3: Fundamental Issues 23

Get Achieving Market Integration now with the O’Reilly learning platform.

O’Reilly members experience books, live events, courses curated by job role, and more from O’Reilly and nearly 200 top publishers.