Building a Competitive and Efficient European Financial Market

Abstract

This study is largely motivated by the ongoing process to revise the Investment Services Directive (ISD). Perhaps the most important aspect of this process is the consequences of the repeal of Article 14(3), which allows national authorities to stipulate that retail investor orders be executed only on a “regulated market” (the so-called “concentration rule”). In the absence of a concentration rule, trades may be executed away from the main market centre. Fragmentation occurs as orders are executed through preferencing arrangements and through in-house matching. This paper focuses on a specific type of preferencing - the internalisation of order flow. The paper also examines the extent to which order flow is internalised in European financial markets. In doing so, it formally defines internalisation and explores its relationship with issues such as market fragmentation and price discovery. It illustrates how internalisation practices differ across each of the major European financial centres and presents new empirical evidence of the possible effects of internalisation on price discovery.

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