Internalization
When a broker fills a customer order from its own inventory rather than routing it to an exchange.
What is Internalization?
Internalization occurs when a broker-dealer fills a customer's order using its own inventory — or through an affiliated market maker — rather than routing the order to an external exchange or trading venue. The broker acts as the counterparty to the customer's trade, capturing the bid-ask spread or a portion of it as profit instead of paying exchange fees. While internalization can sometimes provide price improvement over the NBBO (helping the customer), it can also result in inferior execution if the broker prioritizes its own profitability. Internalization is closely linked to payment for order flow (PFOF), where market makers pay retail brokers for the right to internalize their order flow, a practice subject to ongoing regulatory scrutiny.
Example
When a retail investor places a market order to buy 100 shares of Tesla at $240 through a commission-free broker, the broker may route the order to a market maker that internalizes it — filling the order at $240.01 (one cent above the ask) rather than $240.00, capturing $0.01 per share. The market maker simultaneously buys at $239.99 in the market, earning a $0.02 spread. The customer receives modest price improvement over a hypothetical worse fill but may not receive the best available NBBO price.