How Broker Order Routing Choices Cost the Buy Side Billions

The decisions that brokers make on how to route the buy side's orders to exchanges is costing their clients dearly, to the tune of an estimated $5 billion a year, according to research conducted by consulting firm Woodbine Associates.

In an interview with Advanced Trading, Woodbine principal and equity market analyst Matt Samelson breaks down how the order routing choices brokers make hurts the buy side, what drives a broker to route an order to a particular exchange, and what the buy side should do now to rein in these costs.

Advanced Trading: What drives a broker to route an order to a particular exchange?

Samelson: There are a number of reasons but economics, namely exchange pricing, plays a significant role. Say I'm a broker, and you're my client. You send me 100 shares to execute on your behalf. Acting as your agent, I'm going to charge you a commission. If you're a retail client that commission might be $7.95 from Ameritrade. If you're an institutional client it might be 0.0025 to 3.0 cents per share. I'm going to turn around and work that order subject to your instructions and my fiduciary responsibilities.

[For more on How Pennies Add Up When Brokers Choose the Wrong Exchange.]

There are many ways to fill an order. I'd prefer to internalize it because I can save on hard costs (fees, charges, and commissions) I need to pay if I route to an ATS that I don't own or if I execute at an exchange. Focusing on the exchanges, I am generally charged small fees for taking liquidity and I receive rebates for posting liquidity. These are hard dollars and I pay or receive money from the exchanges at the end of the month. It goes right to my bottom line. If one exchange venue provides superior pricing for volume I have an incentive to route substantial order flow to that venue to maintain my preferred, volume based arrangement. As long as my client is happy with his fill I have done my job.

The incentive that volume based pricing arrangements the exchanges have with brokers has become magnified over the past several years. There is nothing sinister about it. It's a question of pure economics. Client commissions have plummeted over the past decade and brokers, mindful of their bottom line, need to watch their economics. There is where potential conflicts arise.

Advanced Trading: In the long run, how do these routing practices hurt the buy side?

Samelson: As I mentioned earlier, brokers generally pay explicit take fees and receive explicit rebates based upon their order routing. This is real money. These fees and rebates are in the range of 0.0025 per share, give or take. Yet the difference in spread savings between exchanges, on average, ranges from a few one-hundredths (e.g, 0.03) of a penny to a tenth (0.1) of a penny.

These are implicit costs (actually opportunity cost). If I'm a retail client or a buy-side institutional client and I'm generally happy with my fill and I'm not explicitly looking at opportunity cost, I may be letting, on average, a few hundredths of a penny to a tenth of a penny per share in spread savings slide.

Advanced Trading: What should the buy side do?

Samelson: The buy side needs to be their own best friend. They need to do their own analysis. They need to have explicit discussions with their brokers about how they want their orders handled and understand how the algorithms work. They need to get their fills back, periodically look at how the orders are handled, and have discussions with their brokers to ensure they are exposed to the type of liquidity they truly want and to ensure the routing meets expectations We are not talking about micro-managing every trade which would be impractical and not in one's best interest. Furthermore, the buy-side should be willing to pay higher commissions to brokers that deliver truly exceptional performance or provide premium services.

Advanced Trading: Could transaction cost analysis help the buy side weed out these kinds of costs?

Samelson: Yes, but not the way all of these analytics are set up right now. A lot of these analytics are set up to track performance versus benchmarks.. We are talking about a more stringent look at how routing is being done and possible opportunity cost incurred by the buy-side. It is a different kind of analysis.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio