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If a low-cost broker such as Ameritrade routes all its orders to the highest-paying venue—sending all its limit orders to EDGX and all its market orders to either wholesalers or BX—that means its limit orders may not get executed. Imagine that Microsoft shares are trading at $55. You place a limit order to buy 100 shares if the stock falls to $50, and your brokerage routes that order to EDGX, because they pay the most for limit orders.
In a couple of hours, the price dips to $50 and I tell my own broker (who might be the same as yours) to place a market order to immediately sell my 100 shares of Microsoft. But instead of routing the order to EDGX, where I could sell my shares to you, my brokerage directs it to BX (in order to minimize fees), where it finds a different buyer, leaving you high and dry because after I sell my shares, the stock ticks up to $51 and your order goes unexecuted.
True, the brokerage only gets paid for executed trades, but the firm is betting on the fact that if you can’t get the shares you at the higher price. Providing that the second order gets filled, the brokerage still pockets its same commission, but you lose $100 worth of potential profit.
Does the order routing decision matter in the real world? For actively traded, low-priced stocks including Sirius XM Radio and Microsoft, routing orders to the low-fee venue can improve the probability that limit orders execute by up to 25 percent. For higher priced stocks, such as Google, the routing decision is less important.
While the payments seem miniscule, these rebates are a major source of revenue for both brokerages and exchanges—given enough trades, 30 cents per 100 shares can quickly add up. Indeed, prior to the June 17 subcommittee hearing, Ameritrade revealed that it earned revenues of $236 million from order routing in 2013.
But for the average investor, isn’t 30 cents a small price to pay for the $9.99 trading fees that Ameritrade and other low-cost brokers offer? In response to this, Professor Battalio says, “The point is, what’s small? It’s a matter of trust—you’re supposed to be able to trust your broker, and if they’re going to do things to their advantage when they know you’re not looking, is that OK?”
“The point is, what’s small? It’s a matter of trust—you’re supposed to be able to trust your broker, and if they’re going to do things to their advantage when they know you’re not looking, is that OK?” -Robert Battalio