What is Best Execution?
Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.
How Does Best Execution Work?
Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote is $10 per share. Regardless of whether you place the order online or via phone, the broker can choose to send the order:
- to a broker on the floor of a major exchange, such as the NYSE (if the stock trades on that exchange)
- to a broker on the floor of a regional exchange
- to the stock's market maker (if the stock trades on the Nasdaq)
- to a third market maker, which executes trades at publicly quoted prices
- to an electronic communications network (ECN)
- to the broker's own firm, which might sell you the stock out of its own inventory
In our example, your broker might be able to send your order to an entity that is currently quoting $9.75 per share, which would save you $0.25. However, that entity might take longer to execute the trade than a third market maker might, because there are several orders ahead of you. The wait could actually result in a worse price, especially if the stock is volatile. Prices change rapidly in fast-moving markets, and timeliness of trade execution is important, especially to day traders and other investors who trade often.
Why Does Best Execution Matter?
As the circumstances of each order and trading day vary, so does the determination of what best execution is. Although market forces naturally motivate broker-dealers to compete for the best possible price and speed of execution for customers, broker-dealers often receive fees from regional exchanges, third market makers, or particular market makers for sending orders their way. In addition, when a broker-dealer internalizes a trade, it not only makes a commission on the customer's trade, it makes money on the spread. As a result, the broker-dealer's decision on where to route an order is often made under pressure to make money for the customer and the broker-dealer.
Investors do have the right to direct their trades, meaning that they can tell their brokers what exchange, market maker, or ECN they want the broker to use (this may cost extra, however). Investors also have the right to request information about a broker-dealer's policies and payments for its routing practices.
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