July 6, 2011

How Order Routing Affects Your Stock Price

We’re late this week due to celebrations around the anniversary of the rebellion from the Crown. We played croquet, appropriately and cheekily British we thought (no offense to our good friends and former overlords across the pond). Croquet has actual rules we learned.

Sunday, Karen and I loaded the bikes and set out with good friend Jeffrey to conquer the passage between two of Colorado’s tall “fourteeners” named Princeton and Harvard. We rode from the Arkansas Valley floor at 8,000 feet up Cottonwood Pass (which sounds like “cotton whupass”) from Buena Vista to the summit at 12,126 feet and a stunning view of the fruited plain.

Choosing a route from point A to point B had me thinking about stock trades (you do this long enough, that’ll happen to you too). Stock trades must have routes. Sometimes it happens automatically. Whether orders for shares in your stock meet their matches internally at Barclays or by dint of timing, routing, pricing and chance at Susquehanna’s dark pool, RiverCross, often is a matter of routing. Even online brokers afford ways to route trades now.

Most IR folks don’t think about routing. People buy and sell, and that’s that, we suppose. Alas, no. Routing plays a big role in the behavior of your volume. Think about driving across town in a large city. You might take the freeway or you could wander the surface streets. One may get you from point to point faster even if it’s farther, while with the other you’ll see more and maybe check off errands but hit lights.

The same applies to trades. Brokers must report how they route orders (called Rule 606). Routing decisions can change the entire nature of the volume, too. Sometimes it’s how arbitrage occurs – sending orders out on the freeway and on surface streets simultaneously to see how they impact other traffic patterns.

Orders have value too. It’s not just the buying and selling, but the act of buying and selling. Liquidity as commodity is valuable to others. Exchanges pay for it, offering the best incentives to brokers bringing them the most liquidity. Payments are called “rebates.” You can also pay more to get your orders first in line, just like at Disneyland paying extra for a FastPass slots you ahead of the line. Those are routing decisions.

Broker dealers pay for volume too, called Payment for Order Flow. If they aggregate enough volume and send it out to exchanges as what are called “non-marketable orders,” or orders outside prevailing best prices, then that liquidity can earn big payments from exchanges. The exchanges collectively pay about half their gross annual revenues in these “maker” rebates. It’s about routing.

So it’s not just that institutions buy and sell stocks. In today’s markets, decisions about how orders are routed can become investment schemes themselves. Algorithms may route loose, non-marketable volume around throughout the day just to see what it generates in rebates and payment for order flow.

If a trade routes to a broker, who matches the trade internally inside the best prevailing bid or offer, and then that volume starts routing about to generate the sellside firm returns on liquidity, and your price moves as a result, is that rational activity?

No. Rational thought did not change the price; trading activity did. And that’s why Rational Price, our measure of thoughtful investment pricing, is an important distinction from the noise of the market.

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