Seeking a Cure for Low Commissionitis, Big Brokers May Try Internal Medicine

The bulge bracket is hoping it can find a cure for those low-commission blues.
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If the

New York Stock Exchange

floor is truly headed for a future as the city's swankiest squash courts, the competition that pushes it there may come not from electronically enhanced rivals, but from brokerages that now rank among its most influential members.

Major Wall Street firms increasingly are exploring ways to "internalize" trading by matching customer orders themselves, using captive operations on regional exchanges, or using alternative systems such as

Primex

and ECNs to execute trades. They've done this sporadically for years --

Schwab

(SCH)

was among the innovators -- but with commission revenue under siege, they're stepping up their efforts, especially on Big Board listings freed by the repeal of

Rule 390.

With full-service firms venturing into the low-cost electronic trading arena and offering more fee-based accounts, commission revenue is expected to continue shrinking. Securities firms are seeking any method to keep more of that revenue, and eliminating or reducing exchange trading fees and market maker spreads is one way to do that.

Even though internalizing orders may simultaneously lower commission costs for investors and maintain brokers' bottom lines, the

SEC

and some well-placed politicians, notably Sen.

Chuck Schumer

, D-New York, are more concerned about the quality of executions firms provide. Still, it's a cost equation firms can't ignore.

"Firms have to be looking at decreasing the cost of order flow. One of the easiest places to begin is internally matching orders," says Michael Flanagan of

Financial Services Analytics

. "It can produce a significant amount of efficiency that can result in measurable savings."

Internalization may sound a bit heady for Wall Street, but it's a relatively simple process. "An order is like a pinball. You can match it inside or it can be bounced to an ECN, or then to the next best alternative," typically a traditional exchange, says James Freeman, an industry consultant and former top trader at

Credit Suisse First Boston

. "It shows a willingness, even a bravado, by firms to leave the exchange and provide their own liquidity."

And while firms such as

Morgan Stanley Dean Witter

(MWD)

,

Merrill Lynch

(MER)

and

Citigroup

(C) - Get Report

unit

Salomon Smith Barney

explore internalizing orders to save transaction costs, the byproduct could be better executions for investors, whose orders will hit a broader group of potential buyers or sellers. And, of course, it should keep commissions trending downward as the competition for volume keeps exchanges, ECNs and securities firms on a cost-cutting curve.

In this game, size matters. "It all depends on the order flow, it needs to be large and strong to achieve price efficiency," Flanagan says.

The waves of interest are rippling through Wall Street. Gary Kemp, the CEO of

Trading Technologies

, is developing systems that give securities desks the ability to see the market for a stock from several sources, such as exchanges, ECNs, market makers, competing brokerage firms, and especially their own proprietary trading desks. The firm's products, he says, are geared toward internalization efforts, a response "to the realities of where markets are going." His customers -- which he's not disclosing -- are telling the firm, "We want to be a marketplace ourselves," he says.

William Harts, a Salomon Smith Barney managing director, says competition between exchanges and ECNs may push transaction fees down anyway, but that hasn't stopped major firms from working toward an internal option. "Often, the fully integrated firms think they can give clients better execution internally," says Hartz, who's in charge of global portfolio trading at the firm.

Harts declined to comment on Salomon's internalization plans, but with 12,000 brokers serving a huge retail client base and one of the best over-the-counter trading desks on the Street, the firm's clients give it enormous liquidity. The same goes for Merrill and Morgan; each can serve as its own mini-exchange because of its sprawling client base.

Spokespeople for Morgan and Merrill declined to comment.

"One of the good things about competitive pressure is that it creates lower fees for everyone," says Bernard Madoff, the head of

Bernard Madoff Securities

, one of the leading Nasdaq market making firms and one vulnerable to internalization by major houses.

One hurdle, though, may be the SEC. Regulator are casting wary eyes on the practice. A commission spokesman declined comment on the issue but pointed to Chairman

Arthur Levitt's

recent speech at

Columbia Law School

.

"In a fragmented market with internalization, preferencing and payment for order flow, dealers can trade customer orders against their own inventory, without routing them to the best quote," Levitt said. "As a result, there is less incentive to quote a better price."

Internalizing may be easy, but satisfying the SEC may not be. "The SEC, a long time ago, took the position that as long as quality of execution is what it should be," practices such as internalized orders and payment for order flow are acceptable, Madoff says. But "firms that internalize orders will have to meet higher standards."