Joseph Wald, CEO, EdgeTrade, challenges the assumption that smart order routing is the appropriate tool to deal with liquidity fragmentation. The challenge, he suggests, is to bring intelligence to the execution process.
Smart order routing was once promoted in the US as technology's answer to fragmented markets. Now with MiFID-related initiatives promising to reshape the European trading landscape, the term is often heard in conversations across the Atlantic. Has it lived up to its promise? I maintain it has not. To me, the term 'smart order routing' has always seemed like an oxymoron. Both as a concept and in practice, it adopts a very linear approach to a particular problem. It was effective primarily because its ambitions were limited though from the outset, smart order routing had no inherent intelligence. It was not adaptive in nature and basically shot orders out to various destinations in a linear fashion, hoping to exhaust whatever size was available in each venue to complete a particular order.
Why was smart order routing enthusiastically embraced? At the time, it gave traders a competitive advantage in the market place and allowed them to access multiple pools of liquidity that weren't talking to each other. It was a somewhat crude way of addressing that problem, but also relatively effective. Now, however, Reg NMS has made smart order routing obsolete. Moreover, technology has moved on, allowing those with an appropriate understanding of market microstructures to introduce intelligence to the automated search for the other side of a trade. EdgeTrade is easing the process of locating liquidity among fragmented dark pools and public markets with FAN, a smart order execution strategy introduced in September 2006 that proactively "finds and nails" best execution.
'Smart order execution' is adaptive in nature as well as historically based. As with existing order routing techniques it begins with historical data, enhanced in the case of EdgeTrade with proprietary analytics that allow us to glean additional information pertinent to the routing of the order. From that point on, however, the differences with smart order routing become apparent.
As soon as the order has been sent, FAN dynamically receives real-time feedback from actual executions that are occurring in the marketplace. FAN absorbs this information and adapts to it by re-segmenting the order across different locations, in dark pools and public venues, where it has the best chances of execution at that particular moment.
If FAN could talk to itself, it would say something along these lines: " Tell me everything I need to know about this particular order; the nature of the stock; where it trades; who trades it; and how it has been executed over the last X number of days." Based on that information, it sends the order out. FAN posts the order simultaneously to public markets and dark books and, taking advantage of aggregation functionality, re-circulates it to where real time executions are occurring.
Once the order is out, it compares the assumptions it has made based on the historical analytics to real-time feedback. It may then decide to move part of the order from location A to location B because it realises that even though the historical analytics identified an opportunity at a particular venue, the real-time feedback is suggesting something different.
For the trader, this remains virtually a one-touch process. A client enters an order, sends it to FAN, whereupon the system begins to execute the order. As executions come back or as the market moves, the client can either leave the order in the system to execute or modify its parameters.
Alternatives to adding intelligence to the automated search for order execution are few, and some not always in the best interests of the buy-side. For instance, a buy-side trader could negotiate with a full-service broker that also conducts proprietary trading, though this can entail risk. The broker offering capital commitment will not be doing so without consideration for its own gain, often at the expense of the buy-side trading client. The broker will have made a calculated judgement that the terms are to their advantage. The buy-side trader will be left with the problem – say hello to Reg NMS – of proving that it has met its fiduciary duty of achieving best execution. Smart order execution, on the other hand, is a direct and efficient means of empowering the buy-side as they look to take greater control over their own trading and execution performance.
While EdgeTrade coined smart order execution with its category breakthrough launch of Sumo in November 2005, the problems FAN addresses in today's increasingly fragmented market are enormous. Consequently, we expect the term 'smart order execution' to gain currency in the trading community in the months and years ahead.
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