When you click to buy 100 Apple (AAPL) shares using a market order with your online broker, the order is algorithmically routed to a variety of different market centers (market makers, exchanges, ATSs, ECNs), and is eventually filled. On average, the entire process takes a fraction of a second. By the time you navigate to the Order Status page, you will find a confirmation that you now own 100 shares of Apple, purchased at whatever best price your online broker could get you at that moment. Congratulations, your broker just routed your order and you made a stock trade.
SEC Rule 606 Reporting
What happens during the routing process is the (mostly) secret sauce of your online broker. This is known as “order execution quality,” or how well your broker executes your order to get you the best possible fill price (the net price paid for the shares). More specifically, brokers seek to achieve price improvement, which means the order was filled at a price better than the price you saw quoted when you clicked buy. I say, “mostly” because the SEC requires each broker to disclose certain routing and execution metrics in a standard Rule 606 quarterly report.
Unfortunately, the way 606 reports are structured, there is no universal metric that can be pulled and used to conduct an apples-to-apples comparison between one broker and another.
To keep things simple, the most important data that can be extracted from Rule 606 reports are twofold: what percentage of orders are being routed where, and what payment for order flow (PFOF) is the broker receiving, on average, from each venue. Unfortunately, the way 606 reports are structured, there is no universal metric that can be pulled and used to conduct an apples-to-apples comparison between one broker and another. Fortunately, voluntary groups such as the Financial Information Forum (FIF) are working on establishing standards. More on that later.
Generating Revenue from PFOF
While not every broker accepts PFOF, most do, and its industry-standard practice. When you went to buy those 100 shares of Apple, your online broker’s routing system tried to get you the best possible price. Depending on where the order is routed, your online broker can earn a very tiny sum of money on your trade, say $.10 - $.20 in the case of your 100-share market order. Some brokers keep it for themselves, others keep a portion of it and pass the rest back to you; and a handful pass all the earnings back to you. You won’t see it as a cash deposit; instead, you will see that your order was executed at an ever so slightly better price (price improvement).
$.10 - $.20 may not sound like much; however, if your 100-share market order had been a 1,000-share order instead, that payment could have been $1 – $2, or more. The largest online brokers route hundreds of thousands of client trades every day. Known as daily average revenue trades (DARTs), your online broker can make millions of dollars from routing clients’ orders over the course of each year.
Looking at the big picture, there is nothing wrong with this. Revenue from PFOF goes towards paying for all the benefits you take for granted as a client, including free streaming real-time quotes, advanced mobile apps, high-quality customer support, research reports, etc.
Looking at the big picture, there is nothing wrong with this. Revenue from PFOF goes towards paying for all the benefits you take for granted as a client, including free streaming real-time quotes, advanced mobile apps, high-quality customer support, research reports, etc. While discount brokers charging $4.95 per trade or less exist, the reality is that over 96% of retail investors pay at least $6.95 per trade in return for, in most cases, a better overall client experience.
Back to order routing: a slew of factors come into play with your broker’s ability to provide quality order execution. Several of the easiest to understand include:
- What stock is being traded – Companies in the S&P 500, for example, all boast extremely large market caps (they are worth billions) and high average daily volumes of millions of shares per day. This means there is a lot of liquidity (buyers and sellers), which translates into consistently tight spreads (the difference in price between the bid and the ask). On the flip side, a micro-cap stock that trades only 100,000 shares per day, on average, has little liquidity. As a result, spreads are often very wide, which means you are less likely to get a quality, clean fill on your order.
- Order size – You will always achieve better fills when trading small share amounts, i.e., 100 shares. Why? Because the likelihood of someone being there to take the other side and sell you the shares (or buy the shares if you are selling) is extremely high. Depending on the stock (#1 above), the order size is extremely impactful. In a nutshell, the larger your order, the more difficult it is for your online broker to achieve a good fill. Try to imagine what your online broker goes through when you click to buy 100 shares versus say 1,000 or even 10,000 shares, or more. Big difference.
- Time of day – The first 30 minutes and closing 30 minutes of each trading day are the most volatile, meaning stocks fluctuate the most during these times. This means larger spreads, on average. Alternatively, the calmest, least volatile, time of day is around lunchtime, which offers the best odds for a clean, quality fill.
- Order type – The most commonly used order type is a market order, which basically says, “buy or sell these shares immediately at whatever the current market price is.” Limit orders, the second most commonly used order type, on the other hand, say, “buy or sell these shares only at the price I stipulate or better.” As one can imagine, limit orders may sometimes take longer to fill, but have a higher chance of being filled at a better price.
Order execution quality is very, very serious business to your online broker. Every big name online broker has a designated team of specialists who analyze client orders in aggregate with a fine-tooth comb. They also consult with third-party consultants to help break down the data. By analyzing the fill quality of the millions upon millions of trades clients make each month, they can use the data to negotiate with different market makers on behalf of all clients.
Think about it: market makers make money by processing orders. If there are no orders (order flow) routed to them, then they can’t make any money. As a result, market makers compete against each other for order flow, and each online broker chooses which market makers get which orders on our behalf. Our online brokers use this to their advantage for negotiations, as they should.
As we can imagine, the more order flow, or DARTs, an online broker has control of, the more negotiating leverage he has with the varying market makers.
As we can imagine, the more order flow, or DARTs, an online broker has control of, the more negotiating leverage he has with the varying market makers. This is where it gets tricky. To attract order flow, market makers will sell online brokers on two key benefits: price improvement and PFOF (remember, this is paying the broker a tiny sum for each order they send). Make no mistake, there is a difference in the order execution quality market makers provide and how much they will pay out in PFOF.
Thus, here is where the real conundrum lies. Should online brokers focus on negotiating for more PFOF, sacrificing price improvement for their clients in the process, or should they focus on negotiating for greater price improvement and sacrifice generating extra revenue on their clients’ order flow?
Thus, here is where the real conundrum lies. Should online brokers focus on negotiating for more PFOF, sacrificing price improvement for their clients in the process, or should they focus on negotiating for greater price improvement and sacrifice generating extra revenue on their clients’ order flow? Of many debatable takeaways, this is one topic that the book Flash Boys by Michael Lewis brought into the media spotlight when the book was published in 2014.
Quality Versus Payment
To understand the relationship between execution quality and PFOF, think of a dial. The more the dial is turned to the left, the more revenue your broker generates off PFOF, and the less benefit your trade receives. Turn the dial to the right and your broker makes less money off PFOF, and you pay less for your order execution.
Going back to those fancy SEC 606 reports, there is no way to know exactly how each broker’s dial is set. As stated earlier, the reports are outdated and lack universal metrics that allow for direct peer-to-peer comparisons. However, they do require each broker to disclose any PFOF relationship they have with a market maker. They also require each broker to disclose what percentage of clients’ orders, sorted by type, are routed to each market maker.
Using this information, one can take an educated guess (and I mean a guess) as to how each broker has their dial set.
Using this information, one can take an educated guess (and I mean a guess) as to how each broker has their dial set. Our opinion as to how each broker’s dial is set is one component of our ranking system for order execution quality (ranking methodology and results further down).
Size Matters in Negotiations
Now that we understand brokers have a theoretical dial they control, we can discuss one final piece of the puzzle – proper tweaking. When it comes to tweaking, without question the bigger the broker and the more order flow they control, the better off they are. There is a HUGE advantage to being big.
Why size matters is a simple lesson in economics. Let’s say you have online broker A and online broker B. Broker A is small, they have only 10,000 DARTs (order flow) each day. Broker B, on the other hand, has been in business for several decades and built up a large client base with an order flow of 100,000 daily DARTs. So, let’s say Broker A and B decide to route their orders to exactly the same market makers and both want a balance of PFOF with order execution quality. When they go to negotiate, who do you think is going to yield better terms for their clients?
Without question, Broker B. Why? Because this broker has far more leverage at the negotiating table. Furthermore, Broker B, with its size and larger budgets, has a team of order execution experts (see “The Conundrum” above) to collect data on behalf of clients and make sure each market maker they do business with is keeping their end of the deal in providing consistent price improvement.
The takeaway here is twofold. First, size matters in negotiating deals. Second, size provides larger brokers a massive advantage over smaller brokers to tweak their dials. Let’s say a small broker has a dial with five notches, a big broker has probably 20 notches, or more, which brings us to the net cost investors pay per trade.
Declining PFOF is Key, But Not Everything
If you’ve stuck with me this far, you may be asking yourself a very interesting question, “So isn’t the best broker for execution quality the one who doesn’t accept payment for order flow then?” While there is no doubt that any broker who elects not to accept PFOF has, on the whole, focused their dial on price improvement for clients, it isn’t the only magic variable.
Telling a market maker to nix PFOF and focus purely on execution quality is a great step, but if the broker is smaller and has little leverage, they can only monitor and negotiate execution quality so far.
Telling a market maker to nix PFOF and focus purely on execution quality is a great step, but if the broker is smaller and has little leverage, they can only monitor and negotiate execution quality so far. To truly get the best execution, it is a combination of declining PFOF and being large enough to monitor and manage order flow among market makers. This is truly the only way to have the dial cranked all the way to the right.
When you see a broker’s marketed commissions rates (we have each broker’s commissions and fees broken down in extensive detail within their respective review pages), it’s natural to look at the price per stock trade and think that’s that. “Oh, $x per trade, great deal.” As you now know, when order execution quality is factored in, that “great deal” may not be so great after all. It all depends on what you trade (security), when you trade (time), how you trade (size, order type), and how your broker manages its order flow (sets its dial).
For brokers that do accept PFOF, the question is how well do they balance generating extra revenue off their clients’ order flow versus providing the best possible price improvement to save their clients’ money over the long run? Unfortunately, there is no way to know due to the currently outdated SEC Rule 606 reports.
Market and limit orders are the two most common order types used by retail investors. While every broker has an auto (smart) routing option by default, some brokers offer level II quotes with direct-market routing, providing clients the ability to route their orders wherever they’d like. Furthermore, some brokers provide their clients with the ability to manage their market center rebates and fees (see: Best Brokers for Active Trading). Naturally, for sophisticated traders, these options can provide great results if used correctly.
While it is anyone’s guess as to when the SEC will update its Rule 606 reports brokers are required to file each quarter, we are cautiously optimistic it will happen in the next few years. Unfortunately, until changes are made, it is simply not possible to do a true apples-to-apples comparison of order execution quality.
The Financial Information Forum (FIF) has a voluntary “working group” focused on retail execution statistics. Online brokers that participate voluntarily share their execution quality data in an agreed upon format that continues to evolve. While there are multiple groups working towards new and more transparent standards to be considered by the SEC, the FIF has garnered the most credibility. You can find the latest quarterly data for the three brokers that participate, Charles Schwab, Fidelity, and Scottrade, on the FIF website.
In 2015, Fidelity became the first to begin showing per order and cumulative price improvement across each account. For month-to-date, year-to-date, and previous 12-month periods, customers can see exactly how much they paid in commissions, how many trades received price improvement, and the total price improvement. Price improvement means the order was executed lower than the best ask or higher than the best bid at the time of the trade.
How We Scored
Since there is no single universal industry metric yet that identifies order execution quality, we broke the category down into four areas:
- Payment for Order Flow (PFOF) – Brokers earned points for declining payment for order flow with both equities and/or options trades.
- Transparency – Brokers earned points for being members of the FIF and/or displaying execution quality metrics on their websites.
- Market Data & Routing Options – Brokers earned points based on the quality of the quote data they deliver to customers, if they offer level II quotes to customers, and if they provide customers with the capability to directly route orders to different exchanges. For brokers that do offer direct market routing, additional points were awarded to those offering access to four or more venues.
- SEC 606 Reports Analysis – Using all our wisdom and market knowledge, brokers were awarded points based on our estimated correlation of quality routing versus PFOF.
Fidelity and Interactive Brokers came out on top, earning 91% and 85%, respectively, of the total possible points, followed by Charles Schwab and Lightspeed, with scores of 77% and 75%. Fidelity, Charles Schwab, and Scottrade were the only brokers in our Review to voluntarily participate in the FIF. Looking across the industry, only 38% of the brokers have public web pages dedicated to sharing order execution metrics with customers.
When it came to direct routing options, TradeStation, Lightspeed, and Interactive Brokers stood out, earning full points, thanks to offering clients maximum flexibility. Not only do all these brokers offer level II quotes, but clients have numerous options for direct market routing and can even take full control of their routing relationships if they so desire.
Because order execution quality lacks a universal metric for conducting proper comparisons, the category’s weighting in the Overall scoring for the 2017 Review remained low, just 3%.