Changes to market rules in Canada give buy-side firms a choice in smart order routing; but they must ask the right questions before making a decision says Renée Colyer, co-founder of market research firm Forefactor.
Forefactor has published a report, titled ‘Smart order routing in Canada – a cog in the wheel of best execution’, which examines recent changes made to the Canadian equity market and the effect these have had upon order routing for asset managers.
On 1 February 2011 amendments to the National Instrument 23-101 trading regulation created the order protection rule (OPR), which prevents a market executing an order at a lower price if orders on other markets are being displayed offering a superior price.
Previously trade-through protection had only applied to orders on protected markets, named as Alpha ATS, Chi-X Canada, CNSX, Omega ATS, Toronto Stock Exchange and Toronto Stock Exchange Venture by the Investment Industry Regulatory Organization of Canada. This has been changed so that it now applies to a protected bid or protected offer, defined as “an order to buy or sell an exchange-traded security, other than an option, that is displayed on a marketplace that provides automated functionality and about which information is provided to an information processor or an information vendor.”
“The regulators made it easier for everyone to connect to all of the marketplaces,” said Colyer. “You can connect to one marketplace and it has responsibility for checking the others to comply with the OPR.”
To function in line with the OPR, the marketplace or trading venue must use its own smart order router (SOR). However this movement of responsibility from market participants to the marketplaces is not absolute. A buy-side firm can instead use an SOR of its own choosing, relieving the marketplace of the routing obligation by sending a directed action order.
“If a buy-side client chooses to use its broker-dealer’s SOR over the marketplace SOR then the responsibility falls back on the broker once again,” explained Colyer. “The rule effectively allows smaller brokers to participate using a market’s SOR and not have to develop their own.”
When deciding whether to use a broker-supplied SOR or one provided by a marketplace, buy-side firms must ensure they understand the logic and features that each offers, she says.
An SOR has to check across a range of markets, making latency an issue for the system to accurately reflect prices. Latency will be affected by the speed of connectivity from market to market and participant to market – a broker may co-locate its SOR at several markets, whereas a market will effectively be co-located with its own SOR but then relies on the efficiency of the routing infrastructure of other marketplaces to keep the system up to speed.
This reliance on other marketplaces might seem like a weakness, but marketplace SORs have their strengths too. “If the buy-side firm uses the SOR of a marketplace, it gets access to orders that cannot be seen by a broker’s SOR,” said Colyer. “For example, a marketplace can query the flow from an iceberg order that you can’t see and may be able to offer you a better price by providing access to volume that is otherwise unavailable.”
On the other hand she notes that brokers do try and differentiate their SOR offerings by adding value to their tools. “The Royal Bank of Canada’s THOR platform uses a synchronisation logic designed to slow down the speed of high-frequency traders and increase speed of regular traders for example,” said Colyer.
Some broker SORs will access dark pools, although not required to by the OPR, interacting with hidden liquidity that is better priced than that found on lit markets. Just as marketplace SORs have access to liquidity from iceberg orders, if a broker operates its own dark pool it will have an advantage in accessing otherwise hidden liquidity.
Alternative trading system Alpha ATS was granted permission to launch a dark pool, IntraSpread, on 20 April, while brokers Goldman Sachs and Instinet both have outstanding applications to launch dark pools in the country.
Discretionary access to broker crossing networks, as is found in the US, Europe and Asia,could be banned under proposals made by the Canadian Securities Administrators, a national body of regional regulators. This would oblige market operators to provide ‘free and fair’ access to their trading venues, making all liquidity potentially accessible by SOR platforms with the requisite connectivity.
As well as taking on board value-added features, understanding the logic that an SOR uses is crucial to preventing unforeseen consequences Colyer explains. If it operates by sequentially filling an order, the SOR could be gamed by other algorithms.
An SOR may have logic that allows it to route to the US markets, which the OPR does not require but could facilitate best execution. If it does, the exchange rate should be recorded at the time of sale, unless it offers a dual currency facility to operate an offsetting foreign exchange trade at the time.
“The reality is if you have choice you have responsibility,” she said.