Mapping out the best route

Algo use on the buy-side is now way beyond simply being an efficiency tool. It’s all about alpha and seeking out liquidity, which is why brokers are under pressure to prioritise more order-routing transparency.

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Call me clichéd, but it’s all about the liquidity, right? 

Straight up. Regular equity market volatility has had a big impact on algo selection. Algos aren’t just efficiency tools anymore. Traders have portfolio managers breathing down their neck to generate alpha or at least minimise slippage by filling orders fast but liquidity is so fragmented and there’s so much competition for it, I need to know exactly where I’m looking and who else can see me. This means effective transparency on smart order routing has become crucial.

The better your smart order routing, the easier you can find liquidity at the right time and minimise market impact. There’s a lot of short-term players out there with very sophisticated kit, like radar technology which scans markets to find the trades they want. Buy-siders need to tool up so that these short termers can’t use your order flow to gain information about your trade.

How can you be sure your broker’s SOR is doing that? I never really know what’s going on with it! 

Well it's not the easiest thing to penetrate. While brokers seem to be bending over backwards to help the buy-side, tailoring their systems to your needs, a certain amount of opaqueness will always endure over how orders pass through the sell-side’s trading infrastructure.

But closer cooperation with brokers is the best way forward. 2011 was a year where algo development was marked by a more demanding buy-side and this needs to continue into 2012.

Richard Balarkas, president and CEO at agency broker Instinet Europe, has been an outspoken critic of brokers that refuse to provide transparency for their SORs, believing an unwillingness to provide this information is unhelpful to investors and goes against the spirit of the European regulatory framework.

“The market structure we operate in creates conflicts of interest which provide potential opportunities for brokers to manufacture revenue from liquidity at their client’s expense,” Balarkas told me, explaining, for example, that when brokers hold on to orders in their own dark pools rather than exploring as many external venues as possible, those brokers could be acting in their own interest whilst the client incurs an opportunity cost.

The buy-side has known for some time that they need to ask not just where trades were executed, but where stuff has been sent. And the extra pressure on returns – plus last year’s hoo-ha over one block trading venue – means they are more understanding of the logic behind strategies, and insistent and specific in their instructions if they don’t like the results.

I want my broker to do what’s best for me, not use my order for their own purposes. How do I ensure that happens? 

You ask the right questions and make sure you get an honest, comprehensive response. The first question you need to ask your SOR supplier is: Why would you not connect to a particular venue? Balarkas says the answer will tell you how willing a broker is to make sure your order reaches every available drop of liquidity.

Then ask your broker: Unless instructed to do so, why would you deliberately hold on to my order rather than route it to an external venue? Whatever reason is provided for not passing on orders, it must be supported by numbers that prove this policy works in favour of the client.

Now may be a new era of openness between the buy- and the sell-side, but the onus is still on the buy-side to ensure the information they are receiving is the information they want.