Broker routing decisions in limit order markets

Abstract

The primary focus of this paper is to study conflict of interest in the brokerage market. Brokers face a conflict of interest when the commissions they receive from investors differ from the costs imposed by different trading venues. I construct a model of limit order trading in which brokers serve as agents for investors who wish to access equity markets. I find that brokers preferentially route marketable orders to venues with lower liquidity demand fees, driving up the execution probability at these venues and lowering adverse selection costs. When fees for liquidity supply and demand are sufficiently different, brokers route liquidity supplying orders to separate venues, where investors suffer from lower execution probability and higher costs of adverse selection. Bank topics: Financial markets; Market structure and pricing JEL codes: G24; G28 Résumé Cet article étudie principalement les conflits d'intérêts dans le marché du courtage. Les courtiers se trouvent devant un conflit d'intérêts lorsque les commissions qu'ils reçoivent des investisseurs diffèrent des coûts qu'exigent les différentes plateformes de négociation. L'auteur construit un modèle de négociation d'ordres à cours limité dans lequel les courtiers servent d'intermédiaires aux investisseurs qui souhaitent accéder aux marchés boursiers. Il constate que les courtiers préfèrent acheminer les ordres négociables vers des plateformes dont les frais liés à la demande de liquidité sont moindres, ce qui augmente la probabilité d'exécution sur ces plateformes et réduit les coûts d'antisélection. Lorsque les frais associés à l'offre et à la demande de liquidité sont suffisamment différents, les courtiers transmettent les ordres favorisant l'offre de liquidité à des plateformes distinctes; ainsi, les investisseurs voient diminuer la probabilité d'exécution de leurs ordres et subissent des coûts d'antisélection plus élevés.

Order Routing Decisions for a Fragmented Market: A Review

“…Hendershott and Mendelson (2000) show that dark pools 8 obtain a relative cost advantage. Cimon (2021) develop a theoretical model to support the empirical study of broker's routing incentives by Battalio et al (2016b) and confirm that brokers' route order decision is primarily based on the fee, rather than execution quality.…”

“…Retail investors mainly place orders through retail brokers, and retail brokers make the routing decision. At the same time, retail brokers have the incentives to route order based on size of the commission and rebates (Battalio et al 2016b;Cimon 2021). As a result, O'Hara (2015) and Boehmer et al (2021) document most marketable orders placed by retail investors in the U.S. equity market are either internalized or executed by wholesale market makers, which belong to off-exchanges.…”

Optimal Trade Execution in Cryptocurrency Markets

“…It is well understood that an exchange's fee schedule affects trading activity (Lin, Swan, & Harris, 2019), trader's welfare (Colliard & Foucault, 2012), market efficiency (Black, 2022) and has an impact, in particular, on large traders (Panayides, Rindi, & Werner, 2017). Furthermore, Cimon (2021) finds that trading fee schedules affect the routing decision of brokers who execute trades on behalf of their clients. However, the latter is irrelevant in our context because traders generally interact directly with the exchange and are not intermediated by brokers on cryptocurrency markets (Brauneis, Mestel, Riordan, & Theissen, 2022).…”