The order routing enigma

The majority of brokers do not provide the buy-side with full order routing transparency. Hayley McDowell asks whether the buy-side should be probing their brokers to find out where unfilled orders are being sent.

These days, the buy-side is looking to find out more and more about where brokers are sending its orders. For many years now, full broker transparency on order routing has been difficult to attain, but in an environment driven by performance and regulation this is about to change.

There are several reasons why the majority of brokers currently do not - or in some circumstances cannot - provide the buy-side with such a granular level of detail. Legacy systems, conflicts of interest and the fact some buy-side firms are simply not asking brokers for the information, all play a part in keeping the order routing process so enigmatic.

Back when electronic order handling first took off in the trading world, broker systems did in fact send thousands of orders, cancels, executions and messages to buy-side systems. It was a torrent of information the buy-side basically couldn’t handle. In response to this, brokers began to develop filters within their systems to ensure only execution data was sent to asset managers and ever since, these filters have remained in place.

Now the buy-side wants that data back, but the information could prove to be detrimental to brokers who stand to lose a significant amount of business should the buy-side not approve of where orders are being sent. Or, in other words, brokers are at risk of the information being used against them in a competitive sense. For Dan Royal, global head of equity trading at recently merged asset manager Janus Henderson, spotting potential broker conflicts of interest through order routing is a tedious, but necessary process.

“Often we are left at the mercy of the analysis provided by the broker and as buy-siders we can be very sceptical of the data,” he says. “Nobody will tell you if there is a conflict of interest, but if you can uncover that through detailed analysis you can begin the conversation with your broker. Looking at a larger sample of data you can gain a sense of who is doing a better job in routing logic.

“But without routing transparency, we are less informed. Not having the data around venue analysis or how an algorithm is performing in relation to others, puts you in the dark in terms of making informed decisions.”

Avoiding conflicts

Rob McGrath, the former global head of trading at Schroders and now FinTech consultant, tells a similar story to Royal but reiterates a lack of full order routing transparency is not just about avoiding potential broker conflicts of interests, for the buy-side it is all about costs.

He explains being in control of costs on the buy-side is imperative because failing to do so could see other market participants leading your trading strategy, sometimes without your best intentions at heart.

“It was an issue for us at Schroders because we were so aware of trading costs. We implemented trading technologies to optimise and ensure we had full control of those costs,” McGrath says. “It’s important to bear in mind the lack of transparency allows brokers to make more money.”

Jonathan Clark has more than 20 years experience working at various asset management firms including Blackrock, where he headed up equity trading for the Americas. Currently, he is the chief executive of a firm born out of the buy-side’s frustration with obscure, conflicted and costly methods of order routing.

Clark’s time on the buy-side spent battling with the lack of order routing transparency echoes that of both Royal and McGrath. He has witnessed the market cultivate complexity and fragmentation and says this has brought about the need for more transparency.

“Throughout my time on the buy-side, I did a lot of work on broker-routing and order destination analysis,” says Clark, CEO at Luminex Trading & Analytics. “I wanted to know where my orders were going, where I was having success and failures, and which trading venues were charging higher fees for my orders.”  

Alongside the potential for conflicts of interest, the technological architecture is still not up to scratch on the buy- or sell-side. For both, it’s a painful and expensive process to change systems that have been in place for many years. It requires significant investment in not just the technology but development resources if the system in question does not have the capacity to disclose or interpret the data.

Analyse and understand

“There are a lot of levels to the way we look at trading, but the most difficult is venue analysis and order routing logic because of the sheer amount of data and accuracy needed to formulate a holistic view of it,” Royal explains.

At this point it’s natural to question the incentives, if any, for brokers to provide data on such a granular level when the process has so many barriers. Joe Hipps, managing director at Trade Informatics, says there is not enough investment made in systems to make sense of the data. “Considering the fact there is a significant element of complexity in interpreting the data, the sell-side is not in a position to decide what information is relevant if nobody is going to use it.”

In recent years, asset managers have shifted focus towards performance and execution having been driven by regulation like MiFID II and best execution practices. This shift has seen the buy-side’s interest in exactly where brokers are sending their orders grow exponentially.

TABB Group’s most recent annual institutional equity trading transparency report revealed 49% of buy-siders are not satisfied with transparency currently provided by brokers. Of those, the majority cited order routing data as the biggest area for improvement. A significant 37% of those unsatisfied are looking for further granularity specifically on routed order flow, order placement and unfilled shares.

Dave Weisberger, head of equities at ViableMkts, says unfilled order information is imperative for asset managers trying to analyse and understand performance while controlling the costs, conflicts of interest and keeping in line with best execution policy.

“Unfilled order information is vital to the buy-side. The only way to tell if an agency broker is operating in the interests of the client, as opposed to collecting exchange rebates for themselves, is to analyse all the unfilled posted orders to see if brokers have a pattern of ‘chasing the market’ that results in opportunity costs to the client,” Weisberger says.

“It is important since, on balance, net of fees, the market should be indifferent between posting and taking, but brokers, quite often don’t pass through either. Without rebates or fees passed through, therefore, firms will underperform by posting instead of taking in the aggregate,” he adds.

Creating real excitement

As full order routing transparency continues to top the ever-growing list of concerns for asset managers, trading technology companies are slowly but surely emerging to provide such solutions to the buy-side.

Chief executive at Dash Financial Technologies, Peter Maragos, has seen this trend developing first-hand. Dash provides a technology platform offering full order routing transparency, and Maragos says the firm has seen considerable growth in recent years, in large part due to its transparency services.

“Prospects aren’t used to seeing what we provide and it creates real excitement,” Maragos claims. “Order routing transparency has become a genuine issue for the buy-side. With regulations like MiFID II looming and its global impact becoming clear, transparency and unbundling are more relevant than ever to clients globally.“

He adds that in an environment where the buy side’s performance is as scrutinised as it is, being able to fully control orders and gain total, granular level transparency into your execution is imperative. Every basis point counts in terms of execution quality.

Similarly, Clark at Luminex, which provides a fully transparent alternative trading venue for the buy-side that does not route out orders, says there are technology firms in this space that provide market-based solutions to help the buy-side interpret the complex, granular data.

However, as is often the case, the cost of implementing such a system can be one of the most influential factors for asset managers. But in most cases it is a matter of implementing the platform, system or product. 

“There is interest on the buy-side and they want to know more, but often price can be the ultimate determinative. Some will say they prefer to use the traditional methods to evaluate performance rather than go into such granular detail,” Clark says.

In many ways, the buy-side could do more to ensure brokers provide full order routing transparency. Interestingly the majority of brokers are not unwilling to provide the data, but the lack of resources and nagging legacy systems at the majority of asset management firms’ means sell-side firms are often not asked for the information.

Change afoot

The buy-side should be asking their counterparts for full order routing transparency, although the sell-side is in many cases dictated by costs and under the same technological constraints. McGrath argues firms who claim to not have the right technology in place to deal with the often-overwhelming amount of data is not a good enough excuse.

“Over the past year since leaving Schroders, I have worked with several quite small FinTech firms, like Dash Financial Technologies for example, who have less budget for technology than large investment banks, but are able to provide full order routing information. Not having the right technology is an excuse; the reality is the data can be provided if you ask the right people the right questions,” he says.

It’s an unholy alliance between the buy- and sell-side, keeping the system of bundled services in place, and reports detailing any major differences in trading quality between brokers are indeed a threat to that system. But once brokers know they have to analyse all unfilled orders the market will, as it always seems to, find a way to adjust.

Wesiberger says for brokers, it’s a ‘knee-jerk’ reaction to any kind of change whether technologically or in general. The process is costly and so it’s no surprise brokers are in some cases fighting back. In the event that accurate, statistical reporting of order routing becomes universal, “brokers who have not invested in quantitative trading technologies or the ability to provide or source liquidity, stand to lose an enormous amount of business”.

Change is on the horizon. In Europe, MiFID II’s unbundling looks to prevent conflicts of interest through rules around trading inducements. The rules will tackle the need for transparency in not just trade reporting, but order routing.

Similarly, in the US last year the Securities and Exchange Commission (SEC) invited industry comments on the idea of enforcing rules which would require firms to provide this level of granular information. Regulation and the buy-side’s increasing need for full order routing transparency from brokers, could see the issue come to a head sooner than we think.