Did you know that in the split-second between placing the order and order execution, there may be price changes in the underlying asset? It is one of the main reasons why you should carefully choose your broker. But first, here’s how the order execution works.
What’s order execution?
Order execution is when the buying or selling of an underlying asset has been completed. The most common misconception about execution is that when an investor places an order, they would instantly receive it. However, it’s a lot more complicated than that, and sometimes, some orders aren’t executed due to various reasons.
When an investor places an order, the order is directed to the broker. Furthermore, they have options to execute the order.
1. Placing an order
As you know, the trader or investor initiates the process of order execution. For instance, using a trading platform or through the phone, you can indicate the specifics of the asset you want to buy or sell, including the quantity and price you prefer.
2. Routing the order
After placing the order, it’s directed to the broker. The broker has the option to facilitate the execution of your order. Before they choose, they analyse the size of the order and your ability to place it. Once both have been confirmed, the broker tries to fill your request in various ways.
It’s one of the reasons why you should pick the best broker you can find. If the broker you choose can’t make a sound decision for order execution, you’ll have to pay a bigger price, literally.
When it comes to the broker’s options when executing your order, below is the list of these options:
To the floor exchange
When the broker chooses the “order to the floor”, it’ll be directed to the regional or stock exchange. Once the order is directed, a floor broker is assigned to execute the order.
A floor broker, or pit broker, usually represents large companies and well-known investors since there’s limited space in the floor exchange. You can be redirected to this option if you fall under the description mentioned.
Nowadays, floor brokers aren’t as popular as before, due to technological advancements, but they can still be a great option, depending on your broker.
To the third market maker
If your order is directed to another firm called the market maker, your broker might get an incentive for the transaction. So instead of directing your order to the market, the market maker will be the one who’ll buy or sell depending on your order.
Meanwhile, the incentive the market makers receive is also called the payment for order flow since the orders are directed to them.
In some cases, the brokerage firms own stocks, so they can also decide to fill your order based on their inventory. This option is called internalisation, which has a positive effect on them since they can earn profit in this kind of execution.
The profit comes from the difference between the price they’ve paid to buy the underlying asset and the price when they sell it to you.
The Electronic Communications Network (ECN) is a system in which the buy and sell orders automatically match. This option is usually faster than the others, which is why it’s also used for limit orders.
So if you have a Limit Order, your broker might direct it to the ECN and let the technology do its job. And since Limit Orders usually have specific price requests, this is ideal given its instant match feature.
To the OTC market
If your order is directed to the over-the-counter (OTC) market, it means that transactions are not centralised and may be subject to negotiation. But similar to the third market maker, the OTC market enables brokers to make a profit if they direct orders to them.
So compared to other options, the OTC can be more flexible, especially if you have more specific requests. However, this can also have a negative impact depending on the situation.
3. Matching the order
Once your broker selected the option to execute your order, it’s matched to another compatible order. The time it takes for one order to match another depends on the type of execution of the order. Unfortunately, if there are no immediate matches, your order may be placed in a queue until a match comes along.
4. Price discovery and settlement
As mentioned, the price depends on various factors, such as the process of order execution and the broker. It varies if they have additional fees for every transaction and if their chosen process requires you to pay more.
The funds should be ready for transfer to proceed with the order execution, once the price is disclosed.
5. Execution of the order
Once the orders are matched, confirmed, and paid, the trade will be executed. Moreover, the payment will be transferred, as well as the underlying asset and the transaction will be recorded.
Broker’s Duty of Best Execution
Brokers are obligated to provide the Best Execution, which is why it’s advisable to find the best one. The Best Execution or FINRA (Financial Industry Regulatory Authority) Rule 5310 requires brokers to thoroughly assess, track, and provide the most reasonable option to execute orders.
Meanwhile, the requirements in providing the Best Execution include speed, opting for a reasonable price, and probability of executing the order.