Over the past few years, cost-conscious investors watched numerous online brokers eliminate fees for placing equity orders and per-leg fees for options transactions. Those who focused on trading costs as a defining factor in their choice of online broker now must choose some other differentiating factor.
For some, that may be the interest paid on idle cash or on assistance from financial advisors. Other investors may look for tools to evaluate potential trades, ways to calculate the performance of their portfolios, or help with calculating the tax impact of their transactions. The possibility that real-time data and research amenities may be subject to subscription fees in the next couple of years is anticipated by many in the industry. But a very real factor in an investor's profitability is one that can be difficult to calculate: the quality of the order execution once you've hit the "Trade" button. Is your broker routing your order to benefit its bottom line, or yours?Key Takeaways
- Regulation NMS requires your broker to execute your trade at, or better than, the national best bid or offer (NBBO).
- The NBBO is the best available or lowest ask price when buying an exchange-listed product and the highest bid price when selling.
- Some brokers choose to route orders to generate rebates from exchanges and payment for order flow from market makers.
- Where and how your broker executes your trades can impact your total returns based on the focus of its order routing algorithm.
Order Execution Rules for Brokers
There are extensive regulations in place, notably Regulation NMS that was passed in 2005, that require your broker to execute your trade at, or better than, the national best bid or offer (NBBO). The NBBO is the best available (lowest) ask price when you are buying an exchange-listed product and the best available (highest) bid price when you're selling. Now some brokers fight about price improvement on market orders or marketable limit orders, which in essence garners you a lower price when buying or a higher price when selling.
An additional piece of Reg NMS is , which requires broker-dealers routing non-directed orders on customers' behalf to publish quarterly reports that list the venues used for customer orders. Though some brokers allow clients to choose the venue where their order is executed, the huge majority of orders entered on online broker platforms are considered "non-directed." You can find these reports on broker's sites under the heading Rule 606 Reports, though they're not easy reading. Brokers must disclose any venue that receives 5% or more of its order flow. You can also request a report specifying where orders you personally entered were routed for the previous six months.
Some brokers choose to route orders in a way that generates rebates from exchanges and payment for order flow from market makers, while others have developed routing algorithms that seek out better prices for customers.
Order Execution Impacts Your Returns
Fidelity and Schwab's Execution Statistics
Fidelity and Schwab publish execution quality statistics that compare the orders they route on customers' behalf to the NBBO. Here are the most recent figures, which represent the 2nd quarter of 2021.
Fidelity
Customers placing orders of 500-1,999 shares for stocks that trade in the S&P 500 index at Fidelity can see an average savings of $11.17 per transaction. Fidelity Brokerage Services LLC – Retail Execution Quality Statistics Q2 2021
Schwab
Customers placing orders of 500-1,999 shares for stocks that trade in the S&P 500 index at Schwab can see an average savings of $15 per transaction.
Schwab: Retail Execution Quality Statistics (Q2 2021)
In other words, if you place five trades in that range per month, that's another $55.85 in your portfolio with Fidelity and $75 with Schwab.Fidelity and Schwab's War of Words
Once both Schwab and Fidelity dropped commissions to zero, Schwab started questioning the quality of Fidelity's executions. Specifically, Schwab called Fidelity out for routing trades through its affiliate National Financial Services, for accepting rebates from markets where it routes its orders, and receiving payment for order flow on options trades.
Fidelity has stated emphatically that it does not accept payment for order flow on equity trades, and in response to that, Schwab points out that some of the venues to which it routes orders offer it. Fidelity operates an alternative trading system (ATS) for institutional trades and routes some retail orders there that are executed at the midpoint between bid and ask, or better.
A Fidelity spokesperson said that a small number of trades get executed at its proprietary ATS—just 3%—but those trades generate 10% of the firm's price improvement. Orders that are not filled at Fidelity's ATS get routed to other venues. Regarding payment for order flow for options contracts, those markets are structurally different from the equities markets. To get price improvement for a particular options order, Fidelity's router will start an auction on the exchange. Consolidators like Citadel and Susquehanna have affiliate market makers, which Fidelity will use to get price improvement. "We make all of our routing decisions based on the price improvement statistics. We do the exact same thing with options as we do with equities," stated a Fidelity representative. According to this representative, Fidelity's Rule 606 statistics show that it accepts $0.22 in payment for order flow per contract, while Schwab accepts $0.35 and E*TRADE accepts $0.39. One of the executives we spoke to pointed out that brokers don't have to accept payment for order flow even if it's offered. There is a path to take nothing for options order flow or to pass those payments through to the customer, but none of the brokers yet makes that choice. The flaw in Rule 606 reporting, according to an executive at a competing broker who spoke with us on background, is that those reports only show where the trade is actually executed. Fidelity's competitors complain that its order routing algorithm starts out sending customer orders to its own in-house institutional trading system, but most orders end up getting executed elsewhere. This executive said that Fidelity and Schwab both do a good job with execution quality and noted that the composition of order flow differs from firm to firm. "What our clients trade may be different from what a Fidelity client trades," the executive noted.