The Economics of Best Execution
Lawrence Harris, USC Working Paper, March 9, 1996.
Abstract
Three characteristics of US securities markets cause people to question whether brokerage customers obtain best execution when they trade. The first is order preferencing. Brokers commonly send their retail order flows to preferred dealers in exchange for various inducements. The receipt of these inducements at first blush seems inconsistent with brokers' agency duties to their clients. The second concerns the exposure of order flow. Brokers do not expose limit orders to the extent that many limit order traders would like. Finally, no universal mechanism exists in the US markets to ensure that exposed limit orders can compete with dealers to provide liquidity.
This paper surveys some economic principles required to understand these three market characteristics, their effects on best execution, and on how best execution should be best regulated, if at all. The analysis examines best execution for market orders and also for limit orders. The issues considered include
- how competition affects payments-for-order-flow and retail commissions,
- what determines bid/ask spreads, price improvement and order flow inducements,
- why you cannot buy what you cannot audit, and
- why the public limit order traders can crowd-out dealers.
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Last revised 8/5/96.