Market Orders Are Da Bomb

So let's play this out. Say, for example, we have two venues: Exchanges A and B. Both show the exact same offerings, 1,000 shares across five price points from .01 through .05. If a broker has a 6,000-share order, you would expect that each exchange would execute 3,000 shares at the three lowest price points. However, if that order is shipped out to Exchange A for execution, you may get a very different fill.

An Elaborate Example

In this scenario, Exchange A gets the order at millisecond one. At millisecond two, it checks for external liquidity. At millisecond 10 (given an eight-millisecond response lag), it sees that the two exchanges are tied. At millisecond 11, Exchange A takes out its first 1,000 shares. At millisecond 12, it routes an order to Exchange B for the displayed 1,000 shares. At millisecond 13 (before it even gets a fill or anything done from Exchange B), Exchange A begins sweeping its stack. In this example, Exchange A very easily could execute across all five price points before Exchange B responds, pushing up the price to .05 instead of filling the whole order at a top of .03.

But if routing to Exchange A gives you an inferior execution, why would anyone use an exchange to route an order? How about money?

If the exchange can leverage its own liquidity rather than taking liquidity from others, it stands to generate fatter trading and market data revenues, offer lower trading fees, and leverage a more competitive war chest. In addition, the expense of connecting and providing smart order routing to a dozen regional exchanges (if they get off the ground) certainly is expensive and may be out of the budget for many small brokers.

This gets me back to my original point - in a post-NMS world, the market order is king and, while limit orders are nice, the faster and smarter the technology, the less important limit orders become. The other moral of this story is: Be careful how you route. If you really want best execution, it may pay for you to look under the router's hood. Otherwise it may be you who bombs.

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