While some buy-side traders have grasped the importance of smart order routing (SOR), others still have some work to do, according to Jerry Lees, head of alternative execution at agency broker CA Cheuvreux.
“Buy-side firms that use algos or DMA for 25% of their order flow are aware of how important SOR is. If algos don’t access alternative pools they miss out on liquidity and the opportunity for price improvement,” he says. “Buy-side firms in the UK and the US are generally well clued up, but parts of Europe are still in the dark ages to be honest.”
The laggards will soon have impetus to catch up, however. As Cheuvreux’s recent research paper, ‘Navigating Liquidity’, points out, the expected increase in the number of European equity trading venues is likely to accelerate liquidity fragmentation in Europe, thereby underscore the importance of smart order routing.
Lees argues that SOR is already a pre-requisite of providing end-investors with an adequate level of execution. “You can’t take advantage of liquidity options without SOR, even if you just trade on the primary market and Chi-X,” says Lees. “No human being can react fast enough analyse multiple markets efficiently.”
Not only will venues be more numerous in 2009, they will also be more diverse. As new entrants try to attract liquidity and appeal to different sectors of the market through execution fee structures and functionality, Lees says SOR technology needs to take these differentiating factors into account.
“Most of our clients want a heatmap type of product,” says Lees. “If 20% of liquidity in a stock has been on Chi-X and 80% on the primary, you would split the order simultaneously by that ratio.”
Heatmapping is the process by which an SOR tool uses historical data on fill ratios, price improvement percentages and liquidity of different markets, as well as liquidity in specific stocks, to make routing decisions.
But to use SOR effectively across all the new venues, an accurate data feed of European markets is required. MiFID did not mandate a consolidated source of market data for European equities, the absence of which has cause both buy- and sell-side firms to bemoan the lack of post-trade transparency.
However, Lees thinks SOR providers could solve this problem. “The European Commission has said it is not ready to legislate for a consolidated tape because it doesn’t see a clean designable solution and believes market forces will prevail,” he says. “Firms with SOR offerings are creating their own consolidated tape to make price determination easier.”