How orders get to the exchange - YouTube

We've talked about what orders are and

we've talked about what happens to them when they get to the exchange.

Let's talk now about how do the orders get to the exchange from you.

Well, here you are with your laptop connected to the internet and

you've just entered an order to buy some stock.

Your buy order goes over the internet to your broker.

Your broker in turn is connected to several exchanges and

the broker determines where to route your order

based on information it knows about the exchanges.

Let's suppose the exchanges we're looking at are New York Stock Exchange,

NASDAQ and BATS.

For the stocks you want to buy,

each one of these exchanges has its own order book.

Your broker has a computer located at each exchange and it queries

the computer to say, hey, look at the order book and tell me the prices there.

Query has added all the exchanges and your broker gathers and

examines that information and based on that,

routes your order to the exchange that has the best price.

Let's say that's New York Stock Exchange.

Your order enters the exchange, gets executed and the price comes back

to your broker and forwarded back to you and you get a confirmation.

Now it turns out that because this is happening constantly all the time,

there's multiple brokers, hundreds of thousands,

millions of people making orders that the order books at

each of these exchanges tends to be pretty similar.

In other words,

the prices don't differ much between one or another and it's this

sort of pressure that keeps prices the same across these different exchanges.

Let's consider another scenario.

Suppose there's another client of this same brokerage, Joe and

that Joe wants to sell some stock.

Well, the brokerage can observe, hey, I've got some clients who want to sell,

some clients who want to buy.

I can just make that exchange internally and

I don't even need to go to the exchanges.

This can be advantageous for the broker, because a broker doesn't have to

pay now fees to the exchanges for this transaction to occur.

However, according to the law, both the seller and

the buyer have to get prices that are at least as good as they

would've gotten if they had gone to an exchange.

And eventually, at the end of the day,

this transaction has to be registered with one of the exchanges.

Usually, it's recorded at the exchange where that particular stock is homed.

Let's consider one more example.

In this case, Lisa also wants to sell some stock, but

she uses a different broker than you do.

There's one more kind of entity out there called a Dark Pool

that acts as an intermediary between brokerages and exchanges.

So the Dark Pool is looking at the order books of the various exchanges and

they're often making predictions about which direction stocks are going to go.

They actually pay the brokers for

the privilege to look at the orders before they go to the exchanges.

And if they see an advantageous trade, they'll go ahead and take it.

So in this case, this cell might be routed through

the Dark Pool from broker two to broker one.

And again, the transaction never makes it to the exchanges.

In fact, these days, 80 to 90% of what they

call retail traders orders never make it to the exchanges.

They're either executed internally within a brokerage or

filled using a Dark Pool.

The brokerages in the Dark Pools argue that, that's just fine,

because both partners in this transaction are getting prices at least

as good as they would get at the exchanges on the order books.

But they're saving money, because they don't have to pay the exchange fees.

We've talked so far about how the exchanges work and

how the order book facilitates transactions at the exchanges.

Now we've talked about how orders get to exchanges or not.

Now, let's take a look at how hedge funds

can exploit inefficiencies in this system.