With a glut of trading venues arriving on the European equity trading landscape, access to an effective smart order router (SOR) to navigate between them is now crucial for buy-side traders in their quest for best execution.
Many brokers claim that their routers have the most intelligent order routing logic, but what exactly constitutes ‘smart’?
Routing can be split into two parts: the aggressive removal of liquidity from order books; or the passive posting of liquidity, which some market observers see as the more sophisticated element of routing.
“There is an asymmetric sophistication around the two main components of SORs,” said Michael Seigne, head of European algorithmic trading, Goldman Sachs. “The way aggressive orders are handled is very similar between providers and largely technology based, whereas the passive orders are harder to model, requiring a more quantitative and intelligent approach. Therefore the divergence between providers here is much easier to observe.”
The aggressive removal function requires an analysis and prioritisation of factors such as available stock at particular price points, the consequences of splitting an order, settlement costs and overall execution costs. This is broadly akin to the decisions a sales trader may make when deciding where to execute a trade, except an SOR is able to complete this decision process within milliseconds.
Placing passive orders, on the other hand, requires a dynamic rebalancing of liquidity that enables the router to place orders on venues based on historic and real-time stock and venue profiles. For example, a router’s logic for trading UK stocks will be different to that for trading Spanish stocks given the limited penetration of multilateral trading facilities in Spain compared to the UK. Passive order flow must also take into account the nature of the flow with which it interacts, which in most cases will be the aggressive function of other SORs.
“For our SIGMA SOR, we constantly evaluate how sophisticated the market’s aggressive SOR flow is, and we use this information as an input into our passive order strategies,” said Seigne.
Buy-side firms have started to become more wary of routers’ differentiating factors and the dangers of having a ‘dumb’ order router with limited ability to post orders dynamically.
“The buy-side is becoming more confident that it knows what constitutes a broker’s SOR offering,” added Mark Winter, head of dealing at London-based asset management firm Insight Investment. “We need to be sure that the router will be able to act instantly and take account of the constantly changing landscape.”
“There is now more of a realisation by brokers that if you are providing a smart order router, you have to provide services with it that demonstrate robustness, performance, as well as best execution,” said Kevin Covington, managing director, ITRS Europe, a provider of management and monitoring tools.
As smart order routing gradually becomes smarter, it could have a significant impact on where liquidity resides.
“The increased intelligence has got to filter across a wider proportion of the industry, and we expect to see greater use of smart order routing overall,” said Duncan Higgins, head of client relationship management, Turquoise. “When this happens we will see a big rise in the amount of flow executed on MTFs.”
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