Internalization has cropped up as an issue again, especially with the rise of low-priced, high volume stocks that pose special execution problems, especially for the big exchanges.

The Nasdaq is studying the issue--led by chief economist Frank Hatheway--and has found some evidence that too much internalization can harm the quality of trades, notes Traders. Specifically, the study, which is still in progress, finds that when internalization levels are near 40 percent of a stock's volume, price discovery is impaired. The more internalization, the less trading in public markets, which means prices are being determined by a lot less liquidity.

The Nasdaq is obviously concerned about its bottom line, which depends on volume. The heady growth of internalization--to 30 percent last year from 20 percent a year earlier--can't be comfortable. This reflects in part heavy trading volume of low-priced stocks, such as Citigroup and other financial stocks. In some stocks, internalization levels can be much higher than 40 percent. A market rally may lessen the problem. But the fact remains that with internalization comes sub-penny pricing in a lot of cases, which can make the economics of a trade that much more compelling for the trader. Not everyone would view this trend with alarm. 

For more:
- here's the Traders article

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