Is Best Really Better? Internalization of Orders in an Open Limit Order Book

We study the market quality of the Xetra BEST system operated by Deutsche Börse AG, an internalization system designed as part of an open limit order book, which guarantees a price improvement over the inside spread in the Xetra order book. We develop a structural model of this dual market environment and show that adverse selection costs of internalized trades are significantly lower than those of regular order book trade while realized spreads are significantly larger. The cost savings of the internalizer are larger than the mandatory price improvement, suggesting that internalization can be profitable for both customer and internalizer