Internalization
Internalization is the practice by which a broker-dealer executes a customer order against its own inventory or through an affiliated market maker rather than routing the order to a national securities exchange, allowing the firm to capture the spread while potentially offering price improvement to the customer.
Internalization is one of the defining features of U.S. equity market structure and a significant source of debate about market quality, fairness, and the nature of best execution. When a broker-dealer receives a retail customer order, it has a choice: route the order to a public exchange where it interacts with other participants' displayed quotes, or execute the order itself by acting as the counterparty, matching the customer against the firm's proprietary inventory or through an affiliated wholesaler.
In practice, the vast majority of retail U.S. equity order flow — particularly market orders and marketable limit orders from individual investors — is internalized by a small number of large wholesale market makers rather than sent to lit exchanges. Firms like Citadel Securities, Virtu Financial, and G1 Execution Services pay retail brokerages for the right to fill their customers' orders through a practice known as payment for order flow (PFOF). These wholesalers execute the incoming retail orders against their own capital, typically at the NBBO midpoint or at a price slightly better than the best exchange quote, capturing a portion of the bid-ask spread as their compensation.
The regulatory framework governing internalization in the U.S. is set primarily by the SEC through Regulation NMS and Rule 605/606 reporting requirements. While internalization is legal and widespread, broker-dealers are required to demonstrate that internalized executions satisfy their best execution obligations — that customers receive prices at least as good as the NBBO and, ideally, price improvement beyond the quoted best prices. Rule 605 requires market centers (including internalizers) to publish monthly statistical reports on execution quality, including fill rates, effective spreads, and price improvement statistics.
Proponents of internalization argue that it delivers genuine benefits to retail investors. Wholesale market makers are able to provide price improvement — executions inside the NBBO bid-ask spread — more consistently than public exchanges, particularly for smaller retail-sized orders, because the economic model of internalizing known retail order flow allows wholesalers to price that flow more competitively than the anonymous order flow competing on exchanges. Retail orders rarely carry adverse selection risk (they are unlikely to be from informed traders with superior information), so wholesalers can afford to offer better prices.
Critics argue that internalization fragments the market, reduces the volume of orders competing on lit exchanges, widens quoted spreads on exchanges (because the highest-quality retail flow never reaches them), and creates conflicts of interest at the broker level, where the decision of where to route a customer order may be influenced by revenue from PFOF arrangements rather than purely by the customer's execution interests.
The SEC has been actively reviewing payment for order flow and internalization practices as part of its ongoing equity market structure reform agenda. In 2022 and 2023, the SEC proposed new rules that would require a portion of retail order flow to be exposed to competition through exchange-like auctions before being internalized, aiming to ensure that retail investors benefit from the best available prices rather than the prices a single wholesaler chooses to offer.