internalization


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Internalization

A trade between an investor and his/her brokerage. That is, the client makes an order to the brokerage to buy or sell a security and the brokerage fills the order from its own inventory of the security. This can be advantageous to the brokerage because it is less expensive than going out and finding another buyer or seller. Some exchanges prohibit these trades, and brokerages are required to report internalization on exchanges that permit it.

Internalization.

Internalization occurs when a securities trade is executed within a brokerage firm rather than though an exchange. For example, if you give your broker an order to buy, the brokerage firm, acting as dealer, sells you shares it holds in its own account.

Similarly, if you give an order to sell, the firm buys your shares. The transaction is reported to the exchange or market where the stock is listed but the trade is settled within the firm.

Your broker might choose an internalized trade, sometimes called a principal transaction, because it results in the fastest trade at the best price.

The firm keeps the spread, which is the difference between the price the buyer pays and the amount the seller receives. But if the spread is smaller than it would be with a different execution, you, as buyer or seller, benefit.

Your broker may also execute your order by going directly to another firm. In that case, the transaction is reported to the appropriate market just as an internalized trade is, but the recordkeeping and financial arrangements are handled between the firms.

internalization

the combining in one firm of two or more related activities, as opposed to those activities being undertaken separately by different firms and then being synchronized through arms-length MARKET transactions. VERTICAL INTEGRATION where a series of vertically-related operations are combined together is the most frequent example of internalization. Internalization results from firms' desire to reduce their costs by achieving production economies in sequential operations, stock-holding economies and the avoidance of TRANSACTION COSTS in arranging contracts with outside suppliers or distributors. Security of input supplies and access to outlets may be additional considerations. (see also MAKE OR BUY, OUTSOURCING, SOURCING).

Diversified or conglomerate firms which operate in many different markets can internalize the funding of their capital investment programmes by recycling funds from some operating divisions to headquarters, which are then reallocated to other operating divisions. This avoids the need for these divisions to have to raise funds externally through a STOCK MARKET.

Internalization can also be a feature of the FOREIGN MARKET SERVICING STRATEGIES of MULTINATIONAL ENTERPRISES (MNEs); for example, MNEs may opt to replace the licensing of foreign producers and instead set up overseas manufacturing plants, the better to protect and exploit innovatory products. See DIVERSIFICATION, TRANSFER PRICE.

internalization

the combining in one firm or organization of two or more related activities, as opposed to these activities being conducted separately in different firms and then being synchronized through arm's-length MARKET transactions. Economic theory postulates that a PROFIT-MAXIMIZING firm will internalize a sequence of activities if the costs of doing so are lower than transacting the same activities through the market. See TRANSACTION for detailed discussion.

The most common example of internalization is that of VERTICAL INTEGRATION, where a series of vertically related activities are combined. Cost advantages accruing through vertical internalization include reduced production costs by linking together successive processes of manufacture (e.g. iron and steel mills, to avoid reheating) and the avoidance of TRANSACTION COSTS (for example, the costs of drawing up and monitoring CONTRACTS with input suppliers and distributors, MONOPOLY surcharges imposed by powerful input suppliers, etc.).

The concept of internalization is also relevant to HORIZONTAL INTEGRATION by multiplant domestic firms and MULTINATIONAL COMPANIES. In the case of multinational firms, the establishment of production plants in overseas markets, instead of servicing those markets by direct exporting, occurs because of the transaction costs of market imperfections such as TARIFFS, QUOTAS and exchange-rate restrictions and the fact that monopolistic advantages (a patented product, know-how or a unique product) can be better exploited and protected by direct control.

The principle of internalization is also relevant to the funding of capital investment programmes by diversified firms. Such conglomerates are able to recycle funds from some of their operating divisions to headquarters, which are then reallocated to other operating divisions. This avoids the need for these divisions to bear the costs of raising funds externally through the stock exchange.

Internal markets may partly avoid transaction costs, but they involve AGENCY COSTS and also ‘influence costs’ as managers seek to influence the distribution of resources within an organization, for example, divisional managers spending time lobbying head office to support their divisions.

A firm may adopt mixes of internal markets and external markets transactions in its dealings, for example, producing some quantity of a component itself and purchasing the remainder from independent suppliers. See TRANSFER PRICE.

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