Preferencing, Internalization, Best Execution, and Dealer Profits


  • Oliver Hansch,

    1. Pennsylvania State University
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  • Narayan Y. Naik,

    1. London Business School
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  • S. Viswanathan

    1. Fuqua School of Business, Duke University
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    • Hansch is from Pennsylvania State University, Naik is from the London Business School, and Viswanathan is from the Fuqua School of Business, Duke University. Part of this research was undertaken while Hansch was at the London Business School and the Birkbeck College, and Viswanathan was at the Wharton School. We are indebted to Stephen Wells and Graham Hart of the London Stock Exchange for providing us with the data. We are especially grateful to Stephen Wells for his encouragement and support and for several discussions on the issues involved in this paper. We thank Michael Barclay, Robert Battalio, Sudipto Bhattacharya, John Board, Richard Brealey, William Christie, Julian Franks, Bob Goldstein, Bruce Grundy, Roger Huang, Robert Jennings, Eugene Kandel, Pete Kyle, Colin Mayer, Bob Nobay, Maureen O'Hara, Peter Reiss, Eric Sirri, Paul Schultz, Duane Seppi, Hyun Song Shin, René Stulz, David Webb, Ingrid Werner, Pradeep Yadav, two anonymous referees, and the participants in the Dealer Market Conference at Ohio State University in November 1996, the Western Finance Association Meetings in June 1997, the European Finance Association Meetings 1997, and seminar participants at Ohio State University, Oxford University, and the London School of Economics for their comments and suggestions. The authors are grateful for a Q-Group grant for partial funding of this research. Naik is also grateful for funding from the European Commission's Training and Mobility of Researchers program grant (network ref. ERBFMRXCT 960054). We are responsible for all errors.


The practices of preferencing and internalization have been alleged to support collusion, cause worse execution, and lead to wider spreads in dealership style markets relative to auction style markets. For a sample of London Stock Exchange stocks, we find that preferenced trades pay higher spreads, however they do not generate higher dealer profits. Internalized trades pay lower, not higher, spreads. We do not find a relation between the extent of preferencing or internalization and spreads across stocks. These results do not lend support to the “collusion” hypothesis but are consistent with a “costly search and trading relationships” hypothesis.