How Brokers Execute Trades: What Every Investor Should Know

Trade execution isn't instant

Many investors who trade through an online brokerage account assume they have a direct line to the market. They don't. When you click "enter," your order travels to your broker, who then decides which market to route it to for execution. Placing a trade over the phone works essentially the same way, just with a person making the routing decision instead of software.

Execution is usually fast and seamless, but it isn't instantaneous, and prices move quickly, especially in volatile markets. Because a quoted price is only good for a specific number of shares, you may not get the exact price you saw on your screen or heard quoted over the phone; by the time your order actually reaches the market, the price can have shifted, sometimes only slightly, sometimes significantly.

There's no SEC rule mandating a specific execution speed, but firms that advertise their speed can't overstate it or omit the possibility of meaningful delays.

The practical defense against this is a limit order rather than a market order. A limit order only executes at your specified price or better, a buy limit order at the limit price or lower, a sell limit order at the limit price or higher, while a market order gives you no control over the fill price at all. Say a hot IPO opened at $9 and you want in, but you're not willing to pay more than $20. A limit order at $20 protects you from chasing the stock to $90 in the opening frenzy and then absorbing the loss when it settles back down in the days or weeks that follow. The trade-off is that a limit order might never fill if the market price races past your limit before your order can be matched, but that's usually a better outcome than overpaying.

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Where your broker can send your order

Just as you choose a broker, your broker generally chooses among several venues to execute your order.

• For an exchange-listed stock, like one on the NYSE, your broker might route the order to that exchange, to a regional exchange, or to a "third market maker," a firm that stands ready to buy or sell exchange-listed stock at publicly quoted prices. Some regional exchanges and third market makers pay brokers to route orders their way, sometimes a penny or more per share, a practice called "payment for order flow." Firms are required to disclose in writing, at account opening and annually, whether they receive this kind of payment, and to note on trade confirmations whether a particular order generated one.
• For an over-the-counter stock, like one on the NASDAQ, your broker might route the order to a "NASDAQ market maker," a firm that continuously stands ready to buy and sell a particular OTC stock at a publicly quoted price. Many NASDAQ market makers also pay for order flow, and many OTC stocks have more than one market maker competing for that order flow. Market makers generally must be ready to trade at least 100 shares at a time, so a large order may end up split across several market makers, potentially at slightly different prices.
• Your broker may route a limit order to an electronic communications network, or ECN, which automatically matches buy and sell orders at specified prices.
• Your broker may also fill the order internally, out of the firm's own inventory, a practice called "internalization." In this case, the firm can profit from the "spread," the gap between what it pays for the security and what it sells it for.

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Your broker's duty of best execution

Most firms use automated systems to process customer orders, but automation doesn't remove your broker's underlying legal duty to seek the best execution reasonably available. That means periodically evaluating, across all customer orders in aggregate, which competing markets, market makers, or ECNs are actually offering the most favorable execution terms.

A key factor in that evaluation is the possibility, not the guarantee, of "price improvement," an execution at a better price than the current public quote. Speed and likelihood of execution matter too, and there's a genuine trade-off between chasing a better price and the extra time that can take, particularly in a fast-moving market.

Say you place a market order to sell 500 shares at a current quote of $20. If your broker routes it somewhere offering the chance of price improvement and it fills at $20 1/16, you'd receive $10,031.25, or $31.25 more than the quoted price alone. That's a small example, but at scale, and across many trades, a broker's routing choices and price-improvement track record add up.

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Directing your own trades

If you have a reason to want your trade routed to a specific exchange, market maker, or ECN, you can typically ask your broker to do that, though some firms charge extra for the service. Some brokers now let active traders direct NASDAQ orders to the market maker or ECN of their choosing as a standard account feature.

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Disclosure rules on execution practices

SEC rules adopted in November 2000 require market centers trading national market system securities to publish monthly, stock-by-stock disclosures of execution quality, covering how market orders of various sizes were actually executed relative to the public quote, along with effective spread data, the real-world spread investors paid when orders were routed to that market center. Market centers also have to disclose how often they gave limit-order investors a price better than the public quote.

Brokers that route customer orders are separately required to disclose quarterly which market centers receive a significant share of their order flow, and to respond to customer requests about where a specific order was routed within the prior six months.

With that information available, it's worth asking your broker directly about its policies on payment for order flow, internalization, and other routing practices, information that should also appear in your account agreement. If you're comparing brokers, ask each one how often it achieves price improvement on customer orders, and weigh that answer alongside commissions and platform features when deciding where to open an account.

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