Smart Order Routing

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Smart order routing logic
Are all SORs created equal?:
How SORs hunt dark liquidity
Jan Jonsson*
DESICION
Strategy
A s the market matures –
encouraged by the drive for
regulations that seek to bolster
Objectives
standard, fairness and efficiency – it 43
becomes clear that there is a lot of
room for improvement at several
Management
levels of the execution chain.
Any manual interception of an
MACRO LEVEL
order during the execution process Decision
should be questioned.
The context for this article is Choice
smart order routing (SOR) logic
and in particular, the use of dark
pools when executing larger
institutional block trades. ALGO
In order to analyse this subject,
we first provide a definition of the
terms execution and dark.
Execution
SOR
MICRO
The decision to trade is largely Market
governed by three levels of DMA
access *
Jan Jonsson,
decision, ranging from the initial vice president,
product
decision to buy/sell to market Markets management
microstructure considerations: Neonet
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Decision (Portfolio/Fund manager) Grey pools
The strategic decision made by (Broker crossing networks)
a portfolio manager to move Investors are most likely willing to
in to or out of a position leads pay a premium price to complete
to macro level instructions of the order at once with no risk-in-
what instruments to buy/sell, time or price impact. Some dark
quantities, etc. pools match on order price and
volume limits only without using a
Macro Level (Trader, Algorithm) reference price such as the primary
The large order is then divided mid/bid/ask used by dark MTFs.
into smaller, more manageable However, these are not
parts using a certain algorithm that transparent, and harder to
reflects the desired strategy. Each benchmark – you need to trust
smaller part is then transmitted to the provider is not seeking to
the micro level of execution. profit from both commission and
spreads. These venues are often
Micro Level (SOR, Market access) referred to as ‘grey pools’ and may
44 The micro level focuses on the face problems in the future as
optimal execution strategy for each regulators show increasing interest
individual slice of the larger order in tightening the regulation of these
in the best possible way using all venues. Fair, equal, and predictable
available markets and execution behavior is on top of the agenda
channels. today – pushing for more
automation and standardisation.
Dark multilateral trading
facilities How SORs hunt dark liquidity
Dark multilateral trading facilities Dark is used differently at the
(MTFs) are matching engines micro level compared to the
that don’t display any pre-trade macro level and it is important to
information of resting orders to optimise the use of dark in both
anyone and are regulated under channels. However, a common
MiFID with equal access and mistake is to focus on only one part
rules for everyone. To ensure a of the full chain as we will describe
fair price discovery mechanism, later on.
dark pools base their execution
prices on the primary exchanges’ The use of dark pools at macro
mid, bid or ask price. Execution level (Algorithmic execution)
is transparent and easy to As described, executing a large
benchmark. block order typically involves
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dividing it into smaller parts another type of dark execution –
(slices) that are executed over one which attempts to save half a
a period of time, for instance spread in a mid-point dark pool
through using an algorithm. before hitting the lit markets – is
Only a small portion of the total used.
order (one slice) is active in the lit The spread in Europe is
market, while the bulk of the order somewhere between five and 20
‘rests’ in the algorithm. bps, so this equals savings between
This is where dark in its first form 2.5 bps to 10 bps compared to
enters the scene. losing the entire spread by being
At the macro level, dark is a term aggressive. We can trade at the
for the part of an order a broker mid price to save spread, but bid/
executes by trying to find a match ask price points are also interesting,
for the order among its customer since there may be more volume
base, without causing market available at the offer price in the
impact. dark compared to lit. This enables
The hunt for efficiency, investors to beat the weighted
combined with the trend towards EBBO (European best bid and 45
standardised, transparent and offer when volume is taken into
equal treatment of customers via account).
new regulations, has led to an
automation of this process through Are all SOR created equal?
the use of electronically operated As expected, routers comes in
dark pools. various shapes and sizes and are
The part of the order that is not different based on a number of
traded in the lit market is usually factors:
allowed to sweep a number of dark
pools, carefully selected to avoid The creator/owner
unwanted information leakage and Some routers are created by
in conjunction with anti-gaming the buy side for their own use,
strategies. but more commonly a SOR is
provided by the sell-side for its
The use of dark pools at the customers, internal prop flow
micro level (SOR) or a combination of the two.
When the algorithm is executing SORs are also offered by agency
slices that are considerably smaller brokers that serve many sell-
than the big chunk at the macro and buy-side customers that
level, it may decide to send an have different needs. There are
aggressive order to the SOR. Here also technology providers that
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Smart order routing logic
sell standard products or offer Vertical integration
routing customisation. Depending Does the SOR provider control
on the provider, the SOR will reference data, gateways to market,
have different objectives and market data, network and the
functionality. full chain up to the SOR level,
or do they only focus on the
The SOR maturity development of the SOR? This is
An early-generation SOR will critical to the provider’s control
be more blunt and static. Later and understanding of the whole
versions tend to be more dynamic process.
and comprehensive, cleverly
combining lit and dark volumes Business/price model
as well as preventing gaming The result and focus of
attempts. This development never management and the entire
ends, not even with advanced organisation will be widely
mathematical chaos theories different if the SOR provider makes
predicting cause and effect. money on consulting hours, basis
46 point commission on flow they get
Degree of specialisation for providing research, or ideally
Is execution the key consideration if they are paid for the actual
that the SOR provider focuses on, benchmarked performance of their
or is it just an enabler of another execution.
business? At a specialised firm, Depending on the model chosen,
even top management will be the focus may turn to lower
involved in the design and quality internal costs – internalising
of a router and frequently monitor flow (to make money on scale
SOR benchmarks. and possibly make money on
spreads), or hopefully a transparent
Scale good execution that is well
Both an increase in, and benchmarked.
diversification of, flow will speed A commission model may create
up the learning curve for SOR a principal versus agency problem
providers. It will also provide a where a customer wants best
larger set of data to analyse in order execution at the cheapest cost and
to further develop and optimise the the provider has to lower cost to
SOR logic. get a decent margin. Since cost is
easy to measure and quality is hard,
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Smart order routing logic
a cost focus is common, which is essential to know who you are
compromises execution quality. trading with, and their execution
Full transparency would require the intentions. The important thing
SOR provider to report the actual is to make a well-informed
cost of routing to each customer decision with the least amount
plus a totally visible margin. of tradeoffs possible. Dark
pools are rapidly increasing in
Benchmark numbers as institutions fight to
The selection of a benchmark keep internalising flow despite
has the same dramatic impact as impending regulations. At the
business model. At a micro level, same time, huge orders face have a
the focus is around beating the harder time in finding each other.
EBBO, offering price improvement Pegging executions at the mid/
and spread capture. At the macro bid/ask is an easy, well working
level, benchmarks usually include mechanism; but an opportunity
implementation shortfall, VWAP, to trade is missed since big
and other market impact measures. investors are likely willing to pay
One extremely important aspect a premium price if more volume 47
is the criteria needed to include can be done at once. But no one
or exclude venues in different has yet managed to implement
benchmarks. this with trust, transparency and
efficiency. As pure agency brokers,
Summary we are waiting for ‘the pure and
We have explained that all SORs transparent agency large in scale
are certainly not created equal order matching’ – that would bring
and the underlying factors that down the cost for execution to a
contribute to their differences. It fraction of today. n
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