What Is Internalization?

What Is Internalization?

Let me explain internalization to you directly: it's when a business chooses to manage a transaction or project right inside its own operations instead of sending it out to some external party.

You'll see this in all sorts of businesses, from huge multinational corporations to investment firms and brokerages. Even individuals do it sometimes, like when you decide to repair your own appliance rather than hiring a professional.

Understanding Internalization

Think about it this way: internalization happens whenever you or a business opt to deal with a problem or task internally rather than outsourcing it to a third party that's not connected to you.

For companies, this could mean producing a material in-house with your own employees instead of contracting another manufacturer.

When it comes to delivering products, you might find it more efficient to use your own distribution channels rather than hiring an outside shipping company.

This applies to multinational corporations too, where they shift assets between their subsidiaries in different countries.

Benefits and Limitations

One clear benefit of internalization is that it can cut down on what you spend by avoiding outsourcing costs. But it can backfire if handling it yourself ends up costing more than you anticipated.

For instance, you might need to buy extra resources or facilities unexpectedly, assign more employees than planned, or invest more in training than you projected.

Here's a key point: if you're unfamiliar with a job and your team isn't trained for it, or if you lack the expertise, facilities, equipment, or machinery, internalization probably isn't worth pursuing.

Internalized Trading

When you place an order with your broker, they might send it to a market maker or an electronic communications network to fill it. Alternatively, if they have the securities in their own inventory, they could fill it themselves—that's internalization.

Take this example: if a client orders shares of stock, the broker can complete it using their own inventory, which is often cheaper since there's no need to involve an outside firm.

Plus, brokerages can profit from the spread—the difference between what they bought the shares for and what they sell them to you for. And since these sales aren't on the open market, selling a large portion won't influence prices as much.

Internal Sourcing

Internal sourcing is basically a type of internalization where you acquire assets, services, or materials from within your business instead of external sources. This often means producing goods in-house rather than using an outside supplier.

It can also apply to hiring, where you give preference to current employees for vacancies, or keeping activities like marketing within your structure.

Another angle is keeping financing internal, such as reinvesting assets back into the business instead of borrowing or seeking new investors.

Common Questions About Internalization

Does a brokerage always internalize trading? No, they have options for filling orders and must seek the best execution for customers. But if using their inventory is the best and saves money while earning on the spread, they might choose it.

What's a benefit of internalization? Savings—if producing in-house costs less than an external vendor, it's a smart move.

Is internal sourcing different from internalization? It's just a form of it, where you source resources internally from your own employees, materials, or divisions instead of paying outsiders.

The Bottom Line

In essence, internalization is about bringing a job or project in-house when it makes financial sense for you.

Sometimes outsourcing to a vendor is the way to go, especially if you're not equipped to handle it. But if you can project savings and better efficiency by doing it yourself, internalization could be the right choice.