Most investors are unaware that when you place an order with your broker that order is rarely sent to an exchange. Rather, your order is sent to a market maker, who executes the order in a practice known as internalization. Market makers pay kickbacks to your broker for receiving the order, which is known as “Payment for Order-flow.” Payment for order flow (PFOF) is the amount of money brokers receive for routing your buy and sell orders to market makers to be executed. According to Wikipedia, the practice was originally pioneered by Bernie Madoff. For over a decade, the industry has taken differentiating stances on PFOF and the associated conflict of interest with the practice, as there’s very little in the way of disclosure.
All of that changed though when Flash Boys, by Michael Lewis, was published in March 2014. The media took hold and almost immediately the public started asking questions. With greater public awareness and media attention came greater scrutiny over the practice. The debate over order execution quality and PFOF was no longer behind closed doors; it was being conducted publicly. The Securities and Exchange Commission is now increasing its scrutiny of brokers who receive these payments.
Essentially, the more payment for order flow a broker takes, the worse the buy and sell execution prices customers receive. A poor “fill” for your buy or sell order can translate into paying an extra $.01, $.02, or more per share. This may not seem like much, but it adds up quickly. $.01 on 1000 shares is $10, $.02 on 1000 shares is $20, and so on.
To understand the relationship between execution quality and PFOF, think of a dial. The more the dial is turned to the right, the more revenue your broker generates off PFOF, and the less benefit your trade receives. Turn the dial to the left and your broker makes less money off PFOF, and you pay less for your order execution. Brokers have full control of their own dials and can change them regularly and without notice.
The Securities and Exchange Commission requires brokers to disclose order routing and PFOF practices each quarter through standardized 605 and 606 reports. The weakness in the current reporting is in both clarity and depth. There are no universal metrics to determine exactly how far each broker’s dial is turned or how to compare brokers’ actions in this regard. As a result, organizations such as the Financial Information Forum (FIF) have developed voluntary metrics to enhance transparency. Unfortunately, as of early 2016, only a handful of brokers voluntarily participated in the FIF: Charles Schwab, Fidelity, and Scottrade.
To help investors understand order execution quality and payment for order flow, we partnered with the KOR Group and created a brand-new category, Order Execution, for our 2016 Review. KOR Group serves as consultants in the industry, specifically on the topics of best execution, market structure, and order flow.
Since there is no single universal industry metric yet that identifies order execution quality, we broke the category down into three primary areas:
- Transparency – Brokers earned points for being a member of the FIF, displaying execution quality metrics on their website, and/or publicly acknowledging they currently do not accept any payment for order flow.
- 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.
- SEC 605 & 606 Reports Analysis – Using proprietary algorithms provided by the KOR Group, brokers were awarded points based on the correlation of quality routing versus PFOF, as well as the number of venues being routed to.
Fidelity and Charles Schwab came out on top, earning over 60% of the total possible points, followed by TradeStation and Scottrade, with scores of just under 60%. Fidelity, Charles Schwab, and Scottrade were the only brokers in our Review to voluntarily participate in the FIF. Looking across the industry, just under half of the brokers have public web pages dedicated to sharing order execution metrics with customers.
Fidelity, Charles Schwab, and Lightspeed had the highest correlations between routing venues and execution quality. When it came to direct routing options, TradeStation and Lightspeed stood out, earning full points, thanks to offering clients maximum flexibility. Lastly, TradeStation routed orders to the most venues out of any of the brokers.
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 trade.
In today’s current state, with no universal tell-all metric yet available in the industry, customers should focus on transparency, flexibility, and quality. Looking ahead, the new voluntary metrics reported by Financial Information Forum brokers is a positive step in the right direction to learning the truth behind execution quality. While no changes have been officially made yet by the SEC, we are hopeful updates to 605 and 606 reporting will arrive in 2016 or 2017.