Trade Execution: Your Broker might be Ripping you off

Trade execution is the completion of a buy or sell order.

Sounds simple but there is more than meets the eye.

For example, the execution occurs when the order gets filled NOT when the investor places it.

In other words, when you click buy or sell from your phone or desktop that is the initiation, not the completion.

How does the trade execution process occur?

When you send any trade order it goes to the executing broker, who sends it to an exchange to execute it.

When you ‘order,’ it does not guarantee that you will own or sell a stock.

It simply means that your broker is trying to ‘fill’ your order.

When your order status shows ‘filled’ it means that the order has been executed.

(Different online brokers have slight variations. For example, etrade order status might show ‘executed’ instead of ‘filled’)

What is best execution?

Best execution policy means that your broker finds the best price for your order.

At least he should try his best.

In other words, he should give you:

Lowest price when you are buying and the highest price when you are selling financial securities (stocks/shares, bonds, derivatives etc.)

And fast!

‘But isn’t the price of a security listed on an exchange? ‘

Yes it is.

But, it is not the same on every exchange.

At a given time the price of one stock varies from one exchange to another.

I wrote this post which elaborates best execution for equities with the example of Amazon (AMZN) stock price, and shows in real time how it varies on different exchanges.

What of the brokers?

Well, since the broker chooses the exchange it is up to him to trade either in your best interests or his.

Sometimes brokers trade on certain exchanges because the exchange pays them a commission per trade.

Greedy brokers!

They (only the greedy ones) send your orders to the commission paying exchange even if it hurts your portfolio returns.

And you might not get the best price.

BUT!!!

The Securities and Exchange Commission (SEC) has best execution policy whichobligates brokers to trade in the clients’ best interests.

(FINRA Rule 5320 addresses matters of trade execution)

Not only that, the brokers are also required to report their trades to the SEC.

In instances where they are unable to provide best execution they are required to inform their clients as well.

This is the core concept of best execution.

The region a firm operates from determines the governing authority for trade execution.

For example:

• US has Securities and Exchange Commission (SEC)
• Switzerland has Financial Market Supervisory Authority (FINMA)
• UK has Financial Conduct Authority (FCA)

Credible asset management firms mention up front their order execution and allocation policy with clients at the time of signing the contract.

For example, both Credit Suisse and SAMT AG list the securities and the exchange venues to the clients.

Goldman Sachs best execution policy mentions similar obligations.

Why these measures?

Regulatory firms are strict about handing clients’ trades.

The following snippet is from the SEC Website where the case of Dennis Malouf is mentioned for best execution violations.

Dennis J. Malouf (“Malouf”)…. violated, and aided and abetted and caused UASNM, Inc.’s (“UASNM”) violations of, the antifraud provisions of the federal securities laws when he failed to disclose a conflict of interest to his investment adviser clients concerning his order flow to, and receipt of payments from, a broker-dealerbranch that he once owned; and failed to seek best execution for clients.

Also check SEC’s best execution risk alert PDF for July, 2018.

It will also tell you your rights as an investor.

But how to make sure that your broker is executing trades at the best price?

The easiest way is to check the compliance of your broker firm. If your broker is licensed and regulated you don’t have to worry much.

Of course, some brokers could still cheat but those are exceptions to the rule.

Ask your broker firm, asset management or private wealth manager for their compliance in document form.

You can also look at their trade history and portfolio performance. This can be arduous for many retail investors and novices as they will be meddling with trade performance analysis for the very first time.

Anyways, your best execution checklist should:

1. Compare executed price to the market price. If you see that your broker bought stocks for you at $120 per share when on another exchange it was $119, you should investigate.
2. Watch out for spikes in liquidity. Liquidity generally is good but too much liquidity can indicate volatility, and might even cause a delay (slippage) in execution. Note: Too many orders at one exchange can trigger this. Just ask your broker how and where they would re-route your orders in such an event.
3. Make sure that anticipated latency is accurate. Your broker’s hardware, software and execution route could impact latency[1]. You could ask if the broker uses tick-to-trade or similar service to highlight latency issues.
4. Ensure quality and consistency of execution. Self explanatory. It is analogous to a typical trade performance review. Bear in mind this step will make sense after steps 1–3 .

Which broker to choose?

There is no right answer.

Of course, this does not mean that you should pick one from a Russian Roulette.

Research and compare.

Among other measures compare them on: broker premium, speed (of execution), reliability, and cost.

In a broad trade execution speed comparison, the top five best services are:

1. Interactive Brokers
2. Lightspeed
3. TradeStation
4. TD Ameritrade
5. tastyworks

You can read their detailed pros and cons in this post on Investopedia.

What is trade validation?

After trade confirmation, reporting trade details to the authorities and trade settlement, many brokers perform a final check of trade validation.

This reduces risks (operational risk and errors) and gives more control over trades.

It’s not a standard process.

Think about it:

If trade execution services stop after every trade to validate it, it will eat up precious trading time.

The trader/broker needs to decide the number of trades to validate as it affects the Straight Through Processing (STP).

(STP is an objective to execute trades without human intervention)

‘Sounds like a trade off’

Yes it is.

Check out Michael Simmons’ book Securities Operations: A Guide to Trade and Position Management.

It discusses this trade off in exhaustive detail.

The following chart (image credit) is from this books and shows the trade life cycle:

How to measure best execution?

What gets measured gets done (hopefully at a profit).

But measuring execution is not a straightforward process — ‘best’ means different things to different investors.

While determining best execution method you might end up devising your own checklist.

In fact, I encourage it.

Regardless of how you organize your version of ‘best execution analysis,’ trading cost will be the top performance indicator.

Also compare the performance of your broker with other brokers.

The key is to not only look at their past trading cost performance but also at the performance of their traded portfolio.

If they know their craft it should show.

You may read this article from Bloomberg Professional Service, it mentions a study performed in measuring execution performance.

The point is is that an institution’s portfolio performance is a good indicator of how it will handle your trade.

What is MiFID?

The MiFID stands for Markets in Financial Instruments Directive.

It is an EU legislation which regulates firms who provide services to clients regarding financial instruments, and trade venues.

Simply put, MiFID regulates brokers, asset managers etc.

FCA implemented an upgrade, MiFID II directive on Jan 3, 2018.

You can read PricewaterhouseCoopers (PWC) report on the challenges it poses for trading firms here.

The main takeaways from the report are:

1. ‘Quality of execution report’ needs to be published by all exchanges* every quarter.
2. Annual ‘top 5 exchanges’ report.
3. Annual report about the monitoring of the execution quality of all used execution venues.

*(Exchange = Any execution venue).

**(MiFID II defines execution venue as your standard exchange including market makers and other liquidity providers)

If this seems challenging to an investment firm they can hire other wealth managers to provide execution services.

And a lot of firms find it convenient to do so.

The reason?

Execution is becoming complex as electronic trading is growing fast!

If you talk of best execution in algorithmic trading, this is another challenge.

Especially since MiFID II was enforced.

Many brokers had to re-engineer their algorithms regarding how they were executing and accessing exchanges.

But…

This has been great for the retail investor since it has brought more transparency.

It is very easy to tell the difference between research cost and the execution costs.

Previously it wasn’t.

As a result, the quality of best execution reports has significantly increased.

It is becoming difficult for firms to hide behind numbers.

No more hidden costs.

(You can download the current reports on best execution statistics from Xetra and Frankfurt here.)

Previously, brokers would throw in research or ‘access to executives at issuers’ along with the execution cost.

Naturally, portfolio managers would have biases towards certain brokers.

This trend is fading.

Now you can tell if your portfolio manager has a favorite broker.

Also, when looking for an asset management firm, check if they have best execution committee.

These committees serve as quality assurance for your trades.

Big firms like UBS have these committees. But don’t expect to find these with every firm.

And it’s OK.

This is a precautionary measure.

Best Execution of Trade Orders

I will give an overview of trade orders since the focus is on execution.

1) What is a limit order?

A limit order is an order to buy or sell a stock at a specific price OR BETTER.

(A buy limit order can only be executed at the limit price or lower, and a sell limit ordercan only be executed at the limit price or higher)

Best execution protocol works really well in limit order.

Check this excerpt from the SEC website:

The market itself and an alignment of interests between broker and customer ensure best execution of limit orders. With brokers only receiving a commission if a limit order is executed, brokers have every incentive to route orders to markets that ensure the highest likelihood of execution.

It’s a win-win!

2) What is a market order?

When you send a market order your broker buys or sells a security at the best available price in the current market.

The best execution applies here since the broker is to find the best price for you at the earliest.

3) What is a stop loss order?

Stop loss order (or simply a stop order) tells the broker to execute a trade only if a specified price level is reached during trading.

4) What is a stop limit order?

A stop limit order combines a stop-loss order with a limit order. When you send it you enter two prices:

• Stop Price
• Limit Price

If the market reaches the stop price, your order becomes a limit order.

You must carefully read the best execution policy of your broker.

Sometimes these things are hidden in the fine print.

Firms could specifically mention some exceptions which might seem to deviate from best execution.

List down questions about your trades to ask your broker.

How do you compare market order vs limit order?

The table below compares the four main trade orders.

*When placing the order you set the limit price or stop price

Additionally, you can mention time in force when placing order.

Time in force tells your broker how long before the order is executed or expires.

5) What is a not held order? A market or limit order which gives the broker both time and discretion to get the best possible price is a not-held-order.

The best execution of not held orders is tricky.

When the broker has permission to exercise judgement in timing and price, the general requirements of best execution do not apply.

But you can give specific instructions (if any) in advance to the broker.

This FCA handbook lists best execution for all types of trade orders.

[For an in depth look read best execution magazines. Best Execution and The DESKare good sources]

Footnotes

[1] Low latency (capital markets) — Wikipedia