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This Article considers whether securities market strategies designed to profit at the expense of so-called “internalizers” should properly be considered illegal manipulation. An internalizer acquires from a brokerage firm the right to be the market maker for the broker’s full order flow from its retail customers, promising in return to execute each order at a price slightly better than the best price available on any exchange (“price improvement”) as well as to pay the broker a fee for each executed order (“payment for order flow”). Almost all retail trading — about 29% of the country’s total share volume — is executed in this fashion, amounting in 2021 to about $41 trillion in transactions, a figure almost twice the nation’s GDP that year.

The internalizer can run a viable business while promising both price improvement and payment for order flow because retail traders rarely possess information not already reflected in price. This makes the buy and sell orders internalizers receive less dangerous to fill than the more varied order flow going to exchanges. The internalizer’s business model, though, has a vulnerability: a trader can influence what is the best price available on the exchanges and then profit by sending an order to an internalizer that, as a result, executes at a price more favorable to her.

Using a framework that derives its key results from microstructure and financial economics, this Article seeks answers to four questions: (1) Exactly what actions in the market can traders take that would allow them to profit in this fashion? (2) What are the consequences to the various players in the market from traders undertaking such actions? (3) Would it be socially desirable to use legal prohibitions to try to prevent traders from profiting in this fashion? (4) How are such practices treated under existing law, and what reforms, if any, are desirable?

The usual rhetoric concerning the evils of manipulation stresses its unfairness and its distortion of prices. This Article, however, concludes that strategies aimed at profiting off internalizers raise no serious fairness issues. Equally surprisingly, it concludes that if these strategies were freely occurring, they would probably indirectly marginally improve price accuracy. It is unlikely, however, that this effect would be more socially valuable than the practices’ socially negative impact on liquidity. This negative social welfare assessment becomes that much bigger when one adds in the resources consumed by traders engaging in these strategies and by internalizers to protect against them, resources that otherwise would have been available to produce valuable goods and services for society.

The status of these strategies under current case law is uncertain. If they are ultimately adjudicated to be legal, their use would expand greatly. The language of Sections 9(a)(2) and 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 leave room, however, for the development of a coherent doctrine that definitively extends the Act’s prohibitions against manipulation to cover these strategies. The analysis in this Article gives the courts good reasons to do so.


Law | Securities Law