Broker Routing Decisions in Limit Order Markets

Abstract

Many investors do not access equity markets directly; instead, they rely on a broker who receives their order and submits it to a trading venue. Brokers face a conflict of interest when the commissions they receive from investors differ from the costs imposed by different trading venues. Investors want their orders to be filled with the highest probability, while brokers choose venues in order to maximize their own profits. I construct a model of limit order trading in which brokers serve as an agent for investors who wish to access equity markets. When routing liquidity taking orders (market orders), brokers preferentially route to venues with lower fees, driving up the execution probability at these venues and lowering adverse selection costs. However, when routing liquidity supplying orders (limit orders), if routing decisions are driven primarily by rebates from the exchanges, investors suffer from lower execution probability and higher costs of adverse selection. I find that when rebates for making liquidity are sufficiently similar across venues, routing decisions will be driven by the higher execution probability, while if rebates are sufficiently different, routing will be driven by rebates.