SMART ORDER ROUTING: RAISING THE GAME.

Heather McKenzie looks at how SORs are adding value.

In a recent study, equity execution services provider Neonet found that smart order routing (SOR), operating with access to multiple trading venues including MTFs, contributes to raising the overall execution quality available to clients. This results in a significant price improvement when compared to trading on the primary exchange only.

For the study, which was published in February, Neonet combined its equity execution services with analytics and quality assurance tools from IFS LiquidMetrix. Using these tools, Neonet analysed the performance of trade flows on individual or multiple trading venues with millisecond precision – a requirement for evaluating sophisticated SOR engines.

Neonet though is not the only company that has recognised the benefits of SORs, which have become an established technology and form an integral part of algorithmic trading strategies. Smart routers are working at ever faster speeds to compare prices across lit and unlit trading venues, ensuring that they fit within any number of myriad strategies that might be in play at the same time. David Holcombe, specialist in markets and trading at UK-based consultancy, Rule Financial, says smart order routing “is the only way to truly navigate today’s fragmented capital markets in order to get the execution you want and need”.

In February, global investment bank UBS announced the launch of a new algorithmic trading strategy called UBS Swoop, specifically designed for discontinuous liquidity and hard to trade or low-volume securities.

“Traditional algorithms were built to trade on a schedule, which means they are not suited to appropriately capture unanticipated bursts of liquidity,” says Owain Self, global head of algorithmic trading at UBS. “Our clients tell us that at times, for certain securities, they need a strategy to operate on an ‘I would if I could’ basis. So we designed Swoop to wait, watch and intelligently act upon those unpredictable moments.”

The trading strategy employs non-schedule based behaviour that enables the algorithm to capture highly elusive liquidity in an opportunistic way. The liquidity-seeking order type has discretion to trade when appropriate opportunities present themselves and carefully allocate child orders – those that have been separated out from the original order.

Richard Balarkas, chief executive of electronic brokerage Instinet Europe, says SORs are essential for algorithmic trading strategies. “As I speak, the largest venue for trading European shares this morning is Bats Chi-X Europe, not the primary exchanges. To trade well without missing price and liquidity opportunities, you need to trade across multiple venues and to do so successfully, you need a smart order router.”

Tony Nash, head of execution services at Espirito Santo Investment Bank, believes SORs “are more important than any other component of the execution process”. He estimates that the scheduling component of the algorithm accounts for less than 30% of the performance compared with the 70% weighting applied to the SOR. The SOR can turn a well scheduled distribution into a poor execution simply by increasing signally risk or sweeping the venues in a sub-optimal order.

Spoilt for choice

Given the growing importance of SORs, it is unsurprising that there are many solutions on the market. Firms can choose the SOR of their broker or implement off-the-shelf packages from a variety of vendors.

Holcombe says SOR should remain a distinct layer in the technology stack. “SOR needs to focus on ensuring the best outcome for each child order, based on what the client is trying to achieve in balancing the required certainty of execution, versus specific price targets, versus market impact.” The algorithm takes the place of the human sales traders, working each parent order through its lifespan; releasing multiple child orders at predetermined intervals or triggers, seeking to achieve a better average price than would be achieved as a single execution.

“In this way, an institution can quite easily buy an off-the-shelf smart order router, as the mechanics of this are largely commoditised. The algorithm applies the firm’s ‘secret sauce’ – their trading logic that defines the trades they want, and need to do, in order to achieve their trading and investment targets.”

Mark Goodman, head of electronic services, Europe, Société Générale Corporate & Investment Banking (SG CIB), says the bank uses proprietary SOR technology in its algorithms. “We believe our signals-driven approach is unique and we do not believe a third-party platform could support this,” he says. SG CIB’s signals-based model drives the underlying algorithms while also enabling a high level of client-specific customisation.

SORs take on responsibility for the ‘how’ and ‘where’ element of an algorithm, he says. The how relates to “how should I trade this part of the order – should I be passive, aggressive, or rest in the dark, trying to get fills?” Many algorithms will handle the how at the macro level leaving only the where to SORs. “The where is the classic function of a SOR; which venues to post to, where to sweep first, using both dynamic liquidity heat-mapping and historical data analysis to drive decisions.”

Goodman says SG CIB believes this is a fairly limited method. The signals required to optimise how to trade an order can only be optimised using short-term signals which need to be as close to market as possible. Without this approach decisions around passive order placement ignore factors such as volatility prediction, which indicate opportunities for high-frequency and leave the order open to being adversely selected.

“There are many SORs in the market and the solutions they offer generally meet best execution requirements and offer a degree of customisation. However we increasingly find that sellside firms recognise the importance of the continual effort required to keep the SOR logic in line with changing market conditions and provide not just best execution, but a competitive advantage.”

Rather than undertake this investment in technology, resources and time themselves, firms are approaching brokers such as SG who will customise their solutions to these clients’ requirements, says Goodman.

There are two important factors an institution should consider when implementing a SOR, says Balarkas. First, they must ensure that the router is set up and calibrated to operate in the best interests of the client. SORs can be compromised by preferring certain venues, not connecting to some venues, looking for internal crosses over external liquidity, chasing rebates for the broker, etc. Second, firms have to ask how well the router actually works. With prices changing hundreds of times per second across multiple venues, a SOR needs to take information in, act upon it, and get the order out to the best venue with the minimum delay, he says.

Balarkas does not think there is enough information available to assess how good a choice there is of SORs in the market. “I would imagine that if I am a buyside trader looking for a broker’s SOR that connects to every possible source of liquidity, has addressed all possible conflicts of interest in favour of the client and that publishes independently verified results; I might not have that much to choose from.”

Espirito Santo Investment Bank uses its brokers’ SORs, says Nash, but benefits from being able to compare the SOR performance of each executing broker. “It was important for us to be able to manage the brokers’ executions and monitor their SORs. We created a post-trade tool that is unique in the market; it compares the distribution of the venue executions against the consolidated market. This tool enables our clients to accurately compare the performance of the algorithms as well as comparing the venue bias of the SORs being used,” he says.

Nash adds that there is an array of SORs in the market but they vary in quality and price “enormously”. He says it can be a challenge to differentiate between them accurately. An ideal SOR, he says, should simply address the challenge of executing the order in the right venue at the right time and the right price with zero signalling risk.