Question time for brokers

 Buy-side desks in Europe are coming to terms with changing liquidity patterns. As they consider their order routing options, Chris Jackson, director, execution sales, Merrill Lynch International, lays out five questions that European brokers need to be able to answer.

As liquidity disperses   across different venues in a post-MiFID Europe, the solution to fragmentation to a large extent depends on smart order routing (SOR) technologies. There is a broad recognition that these technologies will for the most part be derived from systems originating in the US, though they will need to be adapted to take into account significant differences that exist at the regulatory and market structure level.

MiFID seems to be a product of the EU top-down legislative process. Unlike Reg NMS, it was not driven directly by a regulator connected to the market. As a result, European rules tend to be less granular and more principles-led than US ones. Reg NMS placed detailed constraints and obligations around the dissemination of price and led to brokers offering at least elementary forms of smart order routing across all the trading venues with-in its ambit. By contrast, there is no trade-through requirement from the legislation in Europe. MiFID has left it to the market to decide that process.

Strictly speaking, intermediaries are not required by MiFID to find the best price for each stock traded across all venues at any specific point in time. Without a consolidated tape or US style pass-trough rule such an insistence would be difficult to enforce, so intermediaries are obligated to select execution venues where they consistently achieve best execution. Currently, most participants are looking, as specified under MiFID, for the best price available on these trading venues. Only a few houses are able to look for best execution across all trading venues. With those differences in mind, brokers have invested considerable resources in ensuring that they are demonstrably MiFID-compliant.

Client expectations
MiFID-compliance is, how-ever, one thing and client expectations are another. Our clients want more and they are right to want more. They want transparency and they want as close as they can get to a consolidated tape. In the absence of a trade-through rule, the onus is on Merrill Lynch and our peers to provide a proxy for such a rule through effective smart order routing.

As we know, best execution is not simply a question of finding the cheapest price. We need to take into account the volume that is available at each venue, bearing in mind that there may be a benefit to sitting passively on one of those books for a longer period of time and that there may be higher instances of information leakage or predatory trading on particular platforms.

Faced with a set of MiFID-inspired best execution policies they have already approved, what should the buy-side be asking brokers about how they handle this fragmenting market? I would suggest that they need to ask five key questions of any sell-side professional they might engage to execute their European trades.

Are we there yet?
The first thing clients need to establish is whether their brokers are connected to all the requisite venues through a sophisticated smart order routing mechanism. We have been amazed how few brokers have actually completed that crucial step.

Secondly, clients need to ask what criteria are used to validate each venue beyond price and volume. These may include the extent to which a venue is subject to information leakage. Latency can also be an issue with certain markets. What is the queue time for a particular asset on a specific venue? If my average queue time on market X to become best bid is five minutes and on venue Y with the same price it is 10 minutes, that difference has obvious implications for where the order is placed.

Thirdly, where flow is internalised in dark pools as a source of liquidity, a client should be very clear as to the nature of the counterparties that share that dark pool and the way that interactions take place within it. Who are you crossing with and on what terms are those crosses being exposed? What anti-gaming logic is built into the pool? Are only small orders being pinged to the pool or are clients allowed to remain resident in that pool in size?

A fourth question relates to the dynamic that operates within the smart router itself. If, for example, the router accesses three venues for a particular order and, during the trading process, the relative flow in each venue begins to shift, how does the smart router take those liquidity shifts into account? The trading characteristics of a stock are different on each venue. Minimum spread sizes vary as do incremental price levels across different venues. In addition to price and volume, algorithms and smart order routers need to understand that in choosing where to place an order.

Finally, clients should demand transparency. At the end of each month, for example, brokers should be able to provide a liquidity landscape, showing on which venues client orders have been executed. Armed with answers to all these questions, buy-side traders will be able to make more informed decisions about where and how to commit their flow.