Oliver Hansch
London Business School, London UK
Narayan Naik
London Business School, London, UK
S. Viswanathan
Duke University, Durham, NC 27708
ABSTRACT
The practices of preferencing, internalization and best execution have been criticized as causing poor executions in dealership markets like NASDAQ relative to auction style markets like the NYSE. We study the quality of executions for internalized, preferenced and non-preferenced order flow on the London Stock Exchange for the FTSE 102 stocks (these are the 102 most liquid stocks on the exchange). Our data base allows us to identify the broker who initiates and the market maker who executes every trade. Our results indicate that order flow executed by market makers not posting the best quotes (preferenced order flow) receives significantly worse execution than non-preferenced order flow. Most of this difference is in the largest orders. However, dealers make lower profits on the preferenced order flow than on the non-preferenced order flow because the large preferenced order flow results in subsequent price moves that are deleterious to the market makers. Overall, this results in dealer profits that are not significantly different from zero. Finally, we do not find any significant relationship between the extent of preferencing and size of spreads. In particular, cross-sectionally, we do not find any relationship between spreads (inside, effective and realized) and the extent of preferencing in our sample of 102 stocks.