August 2008


Nicholas Pratt finds out what fund managers should be asking of their
dealing counterparts in determining just how smart their smart order
routers are ... Like many financial technology developments, smart order routers (SORs) began in the US before they came to Europe. In the 1990s a number of electronic communication networks (ECNs) set themselves up as alternative exchanges and the regulations were amended to allow stocks to be listed on more than one location.

As the number of potential venues grew, trading houses began to develop the technology that would allow them to automatically trawl the market looking for best prices rather than having to cast a human eye over multiple screens. More recently the US regulators introduced Reg NMS, which made it a legal requirement for trading firms to execute at the best available price and, with more than 50 possible venues to choose from, to use smart order routing.

Europe has now gone down a similar path with last year’s introduction of MiFID, albeit with a more principles-based approach in comparison to the prescriptive nature of the US regulations. European trading firms are obliged to take all reasonable steps to pursue best execution for their customers and while there is no mandatory order to use smart order routing, the regulators are hoping that the commercial imperative will be strong enough for firms to adopt smart order routers. As Richard Evans, global head of electronic exchange services at Citi, says: “I can’t conceivably imagine how you can claim to offer to best execution and not have smart order routing.”

Although the concept behind smart order routing is straightforward, the providers of the technology insist that the more sophisticated products on offer are anything but straightforward and, according to Evans, “it can get very complex very quickly”. For example, where a stock may be available at one venue between 100 and 102 and between 101 and 102 on another, the more sophisticated SORs will take into the account the respective refresh rates of each venue or whether one accepts ‘iceberg’ orders.

According to Tim Wildenberg, head of the direct execution business for equities in Europe at UBS, there are essentially three different levels of smartness when it comes to smart order routing. “The simplest SORs are the out-of-the-box ones marketed by vendors to certain banks and brokers that have no desire to do any coding or software development of their own.  They will just spot and sweep the market in a fairly non-discretionary way,” he says. “The more complex routers are a bit more discerning about how they sweep the market. They take an historical view of the liquidity and use the probability gained form this historical context to base its routing decisions on.”

The state-of-the-art routers are more dynamic and able to change as the market does, says Wildenberg. “They are assessing liquidity on a real-time basis and know what time to look in the market, how other people may behave in the market. Very few firms have this level of sophistication as they are xpensive to develop and to keep constantly updated.”

The providers of these sophisticated routers tend to be the major trading and investment banks, such as Citi (which acquired Lava some years ago, one of the forerunners of smart order routing), UBS (which includes a smart order router as part of its advanced execution services along with algorithmic trading direct market access) and Goldman Sachs (which has a product called Sigma).

Like UBS, Goldmans offers Sigma as part of its overall execution services and, according to Bryan Koplin, executive director at Goldman Sachs, it is important to judge smart order routing in the slightly wider context of execution services and performance. “We work hard to ensure our SOR component is the best in class but we also don’t manage our SOR in isolation,” says Koplin. “There re many other properties to consider such as algorithms, quantitative metrics (pre- and post-trade), access to internal/external liquidity, amount of crossing nd other issues that contribute o performance.”

Multi-provider approach
Despite Koplin’s assertion that SOR and other execution services should not be looked at in isolation, it is possible to source these services from different providers rather than having a bundled solution. Nevertheless, most clients see the benefit of these ‘total’ solutions to maximize execution performance and simplify the process and investment. Koplin says: “For us it is about making the buy-side dealers look good to their fund managers.”

Fund managers are beginning to show more interest in the quality of their execution and the role that execution services and smart order routing can play in all of this, particularly those that have already gone through the fragmenting liquidity and multiple venues development that has occurred in the US, says Koplin, although he adds that it would be an over-simplification to say that Europe will follow an identical path in its post-MiFID phase. “There are differences in clearing and settlement, regulation and the political geography, but there will be certain themes that will feature in both markets, such as fragmentation and dark liquidity. If anything, the key difference is that the changes will happen at a much greater pace n Europe.”

Just as Wildenberg identified three different classes of smart order routers, he also believes that there are currently three types of fund managers when it comes to smart order routers. “Some do not care and are happy to leave it all to the broker. Others want to redesign it for you and finesse and tune the technology to suit their behaviour. And there is a third group that are happy to leave you to it, satisfied that the quality of execution will be evident in subsequent reports.”

At the moment though, smart order routing is still a relatively young development, as is the fragmentation of liquidity which is yet to really occur. Consequently many fund managers could operate without SOR currently but this ill change, says Wildenberg. “Later this year we will see more venues set up, such as Turquoise, BATs Trading, Nasdaq and others so I an see the need for SOR becoming more urgent by the end of the year.”

And when this point arrives, what should fund managers e asking when trying to ssess the merits of various SOR providers? “They should e asking what venues the router is connected to and to ee evidence of this,” says Wildenberg. “It is also about understanding the posting methodology. Some use SOR as  way of reducing their own
costs rather than achieving etter execution.”

Fund managers should be asking for more transparency from their dealers so that they can understand who exactly is offering what, says Koplin. “They should be asking what type of liquidity they are connected to, what the rules of engagement are and what the logic behind it is. Also, it is not just about SOR for electronic trading. There has to be access to the same tools for traditional upstairs single-share and programme trading flow for non-capital commitment business.”

Are they experienced?
According to Citi’s Evans, fund managers should consider the level of experience that a smart order router provider can boast of. “Anyone can create an order router that just shows the cheapest price but there are many other things to consider.” These considerations include the level of latency – although this is currently a very difficult property to measure due to the fact that there are so many different interpretations of what low latency is and how it should be measured; the number of markets the SOR connects to already rather than what markets it may be considering joining when the European landscape starts to become more populated with alternative venues.

The reliability requirement
And finally the SORs need to be reliable. Many smart order routers in the US suffered an outage in the middle of August 2007 when there was a massive increase in trading volume and those affected have since made efforts to improve heir product’s capacity. Future development also includes adding more venues as well as more capacity, reducing more data and providing clients with more xplicit data as regards the better prices that have been achieved y using SORs to source off-exchange liquidity that can produce better pricing.

The emphasis on transparency and a steady stream of reports that demonstrate where SORs have led to better pricing means that the broker dealers must be prepared to provide this explicit information and be willing to put their services up against that of their peers and suffer the risk of possibly being below a competitor in terms of execution. But for the most part, they seem more than willing to provide such reports, confident that it will show just what kind of basis point benefits smart order routing can provide.

As Koplin says: “Fundamentally, smart order routing and the related execution services are all about providing consistent execution quality for our clients. We are happy to have explicit conversations with fund managers about what we offer and the results we generate. As fund managers learn more about execution services and smart order routing they will be able to ask better questions.”

© 2008 funds europe

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