Smart order routing

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Smart order routing (SOR) [1] [2] is an automated process of handling orders, aimed at taking the best available opportunity throughout a range of different trading venues.

Contents

The increasing number of various trading venues and MTFs leads to a surge in liquidity fragmentation, when the same stock is traded on several different venues, so the price and the amount of stock can vary between them. SOR serves to tackle liquidity fragmentation, or even benefit from it. Smart Order Routing is performed by Smart Order Routers - systems designed to analyze the state of venues and to place orders the best available way, relying on the defined rules, configurations and algorithms.

History of Smart Order Routing

1980s

The forebears of today's smart order routers appeared in the late 1980s: "In an attempt to lock in the client order flow and free traders up from smaller trades, in order to handle the larger trades, many of the larger broker dealers began to offer a new service called Direct Order Turnaround or DOT. [3] DOT boxes were the first electronic machines to provide the institutional buy-side with what we now call "direct sponsored access", they, however, were not very smart yet (they could be directed to only one destination, the New York Stock Exchange)". [4]

By 1988, SuperDOT included "roughly 700 communications lines that carry buy and sell orders." [5]

1990s

It was in the US, in the late 1990s, that the first instances of Smart Order Routers appeared: "Once alternative trading systems (ATSes) started to pop up in U.S. cash equities markets … with the introduction of the U.S. Securities and Exchange Commission’s (SEC’s) Regulation ATS and changes to its order handling rules, smart order routing (SOR) has been a fact of life for global agency broker Investment Technology Group (ITG)." [6]

2000s

As a reaction to the introduction of MiFID (Europe) and Reg NMS (USA), Smart Order Routers proliferated in Europe in 2007–2008, their sole purpose consisting in capturing liquidity on lit venues, or doing an aggressive or a passive split, depending on the market data. Later the SOR systems were enhanced to cope with High Frequency Trading, to decrease latency and implement smarter algorithms, as well as work with dark pools liquidity. [7]

Here are some US statistics from 2006-2007: "Smart order routing capabilities for options are anonymous and easy to use, and optimizes execution quality with each transaction". "In a study conducted earlier this year in conjunction with Financial Insights, BAS found that about 5% of all equity orders were executed using trading algorithms, with this number expected to increase to 20% by 2007". [8]

Smart order routing may be formulated in terms of an optimization problem which achieves a tradeoff between speed and cost of execution. [9]

Benefits and disadvantages of Smart Order Routing

SOR provides the following benefits: [10]

There are, however, some disadvantages: [10]

A brief concept

The idea of Smart Order Routing is to scan the markets and find the best place to execute a customer's order, based on price and liquidity. [11]

Thus, SOR can involve a few stages:

1. Receiving incoming orders through different channels:

2. Processing the orders inside the SOR system, taking into account:

Venue parameters, such as average latency, commission, and rank can be used to prioritize certain venues. Custom algorithms, like synthetic orders (peg, iceberg, spraying, TWAP), can be used to manage orders automatically, for instance, if a specific client has certain routing preferences among several brokers, or certain rules for handling of incoming, or creation of outgoing orders. It is also crucial to track the actual venue situation, like the trading phase, as well as the available opportunities. Thus, any Smart Order Router requires real-time market data from different venues. The market data can be obtained either by connecting directly to the venue's feed handlers, or by using market data providers.

3. Routing the orders to one or several venues according to the decision made at step 2 using:

Routing here does not just imply static routing to a certain venue, but dynamic behavior with updates of existing orders, creation of new ones, sweeping to catch a newly appeared opportunity.

Smart Order Routing system structure Smart order routing system.png
Smart Order Routing system structure

At a closer look, the structure of the SOR system usually contains:

Algorithmic trading and SOR

The classic definition of Smart Order Routing is choosing the best prices and order distribution to capture liquidity. "Forwarding orders to the "best" out of a set of alternative venues while taking into account the different attributes of each venue. What is "best" can be evaluated considering different dimensions – either specified by the customer or by the regulatory regime – e.g. price, liquidity, costs, speed and likelihood of execution or any combination of these dimensions". [12]

In some cases, algorithmic trading is rather dedicated to automatic usage of synthetic behavior. "Algorithmic trading manages the "parent" order while a smart order router directs the "child" orders to the desired destinations." [4] "... slicing a big order into a multiplicity of smaller orders and of timing these orders to minimise market impact via electronic means. Based on mathematical models and considering historical and real-time market data, algorithms determine ex ante, or continuously, the optimum size of the (next) slice and its time of submission to the market. A variety of principles is used for these algorithms, it is aimed at reaching or beating an implicit or explicit benchmark: e.g. a volume weighted average price (VWAP) algorithm targets at slicing and timing orders in a way that the resulting VWAP of its own transactions is close to or better than the VWAP of all transactions of the respective security throughout the trading day or during a specified period of time". [12]

However, smart order routing and algorithmic trading are connected more closely than it seems. Since even Smart Order Routing can be considered the simplest example of algorithm, it is reasonable to say that algorithmic trading is a logical continuation and an extension of Smart Order Routing.

This is a common example of a simple Smart Order Routing strategy.

Having the initial Order Book, the SOR strategy will create child orders, that is orders which aim at completing the initial SOR parent order. These orders can either be aggressive or passive depending on the current context and the SOR algorithm. In this example IOC (immediate or cancel) orders are used:

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
100@21.5200@21.5300@21.6

1) An SOR Buy Day order for 1000@21.5 comes;

2) Aggressive child order to grab opportunity on preferable venue created: Buy IOC 100@21.5;

3) Aggressive child order to grab opportunity on Venue 1 created: Buy IOC 200@21.5;

4) The remaining part placed passive to the Preferred venue:

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
700@21.5300@21.6

5)New liquidity on Venue 2 appears: Sell 150@21.4:

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
700@21.5150@21.4
300@21.6

6)The algo "sweeps" from Preferred venue to grab the opportunity on Venue 2: Buy 150@21.4 IOC

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
550@21.5300@21.6

7)New liquidity on Venue 1 appears: Sell 600@21.5:

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
550@21.5600@21.5300@21.6

8)The algo "sweeps" from the Preferred venue to grab the opportunity on Venue 1: Buy 550@21.5 IOC

9)The trade happens, the algo terminates because all the intended shares were executed:

Preferred venueVenue 1Venue 2
BuySellBuySellBuySell
50@21.5300@21.6

As there are latencies involved in constructing and reading from the consolidated order book, child orders may be rejected if the target order was filled before it got there. Therefore, modern smart order routers have callback mechanisms that re-route orders if they are rejected or partially executed.

If more liquidity is needed to execute an order, smart order routers will post day limit orders, relying on probabilistic and/or machine learning models to find the best venues. If the targeting logic supports it, child orders may also be sent to dark venues, although the client will typically have an option to disable this.

More generally, smart order routing algorithms focus on optimizing a tradeoff between execution cost and execution time. [9]

Cross-Border Routing

Some institutions offer cross-border routing for inter-listed stocks. In this scenario, the SOR targeting logic will use real-time FX rates to determine whether to route to venues in different countries that trade in different currencies. The most common cross-border routers typically route to both Canadian and American venues; however, there are some routers that also factor in European venues while they are open during trading hours.

Development and testing

Providers

Testing

There are currently few companies, officially defined as providers of testing and quality assurance of the SOR systems:

Related Research Articles

<span class="mw-page-title-main">Day trading</span> Buying and selling financial instruments within the same trading day

Day trading is a form of speculation in securities in which a trader buys and sells a financial instrument within the same trading day, so that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open. Traders who trade in this capacity are generally classified as speculators. Day trading contrasts with the long-term trades underlying buy-and-hold and value investing strategies. Day trading may require fast trade execution, sometimes as fast as milli-seconds in scalping, therefore direct-access day trading software is often needed.

An electronic communication network (ECN) is a type of computerized forum or network that facilitates the trading of financial products outside traditional stock exchanges. An ECN is generally an electronic system that widely disseminates orders entered by market makers to third parties and permits the orders to be executed against in whole or in part. The primary products that are traded on ECNs are stocks and currencies. ECNs are generally passive computer-driven networks that internally match limit orders and charge a very small per share transaction fee.

In finance, volume-weighted average price (VWAP) is the ratio of the value of a security or financial asset traded to the total volume of transactions during a trading session. It is a measure of the average trading price for the period.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.

An order is an instruction to buy or sell on a trading venue such as a stock market, bond market, commodity market, financial derivative market or cryptocurrency exchange. These instructions can be simple or complicated, and can be sent to either a broker or directly to a trading venue via direct market access. There are some standard instructions for such orders.

Best execution refers to the duty of an investment services firm executing orders on behalf of customers to ensure the best execution possible for their customers' orders. Some of the factors the broker must consider when seeking best execution of their customers' orders include: the opportunity to get a better price than what Is currently quoted, and the likelihood and speed of execution.

Direct market access (DMA) is a term used in financial markets to describe electronic trading facilities that give investors wishing to trade in financial instruments a way to interact with the order book of an exchange. Normally, trading on the order book is restricted to broker-dealers and market making firms that are members of the exchange. Using DMA, investment companies and other private traders use the information technology infrastructure of sell side firms such as investment banks and the market access that those firms possess, but control the way a trading transaction is managed themselves rather than passing the order over to the broker's own in-house traders for execution. Today, DMA is often combined with algorithmic trading giving access to many different trading strategies. Certain forms of DMA, most notably "sponsored access", have raised substantial regulatory concerns because of the possibility of a malfunction by an investor to cause widespread market disruption.

Regulation National Market System is a 2005 US financial regulation promulgated and described by the Securities and Exchange Commission (SEC) as "a series of initiatives designed to modernize and strengthen the National Market System for equity securities". The Reg NMS is intended to assure that investors receive the best (NBBO) price executions for their orders by encouraging competition in the marketplace. Some contend that the rule has contributed to the rise of high-frequency trading, which is sometimes regarded as controversial.

In finance, a dark pool is a private forum for trading securities, derivatives, and other financial instruments. Liquidity on these markets is called dark pool liquidity. The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of electronic trading platforms has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements. Generally, dark pools are not available to the public, but in some cases, they may be accessed indirectly by retail investors and traders via retail brokers.

In capital markets, low latency is the use of algorithmic trading to react to market events faster than the competition to increase profitability of trades. For example, when executing arbitrage strategies the opportunity to "arb" the market may only present itself for a few milliseconds before parity is achieved. To demonstrate the value that clients put on latency, in 2007 a large global investment bank has stated that every millisecond lost results in $100m per annum in lost opportunity.

A multilateral trading facility (MTF) is a European Union regulatory term for a self-regulated financial trading venue. These are alternatives to the traditional stock exchanges where a market is made in securities, typically using electronic systems. The concept was introduced within the Markets in Financial Instruments Directive (MiFID), a European Directive designed to harmonise retail investors protection and allow investment firms to provide services throughout the EU.

Payment for order flow (PFOF) is the compensation that a stockbroker receives from a market maker in exchange for the broker routing its clients' trades to that market maker. It is a controversial practice that has been called a "kickback" by its critics. Policymakers supportive of PFOF and several people in finance who have a favorable view of the practice have defended it for helping develop new investment apps, low-cost trading, and more efficient execution.

High-frequency trading (HFT) is a type of algorithmic trading in finance characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons in trading securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

Flash trading, otherwise known as a flash order, is a marketable order sent to a market center that is not quoting the industry's best price or that cannot fill that order in its entirety. The order is then flashed to recipients of the venue's proprietary data feed to see if any of those firms wants to take the other side of the order.

MT4 ECN Bridge is a technology that allows a user to access the interbank foreign exchange market through the MetaTrader 4 (MT4) electronic trading platform. MT4 was designed to allow trading between a broker and its clients, so it did not provide for passing orders through to wholesale forex market via electronic communication networks (ECNs). In response, a number of third-party software companies developed Straight-through processing bridging software to allow the MT4 server to pass orders placed by clients directly to an ECN and feed trade confirmations back automatically.

Ultra-low latency direct market access is a set of technologies used as part of modern trading strategies, where speed of execution is critical. Direct market access (DMA), often combined with algorithmic trading is a means of executing trading flow on a selected trading venue by bypassing the brokers' discretionary methods. As defined by the International Organization of Securities Commissions (IOSCO), DMA arrangement is a process by which traders transmit orders on their own, without any handling or re-entry by another person, directly into the market’s trade matching system for execution. Because of the lack of interaction with the broker, this is sometimes referred to as no-touch. DMA flow passes directly through the DMA gateway and onto the venue while passing through strict risk checking and position keeping algorithms. It is at this point that brokers may monitor the behaviour of their DMA clients.

A foreign exchange aggregator or FX Aggregator is a class of systems used in Forex trading to aggregate the liquidity from several liquidity providers.

<span class="mw-page-title-main">LMAX Group</span> Financial technology company

LMAX Group is a global financial technology company which operates multiple institutional execution venues for electronic foreign exchange (FX) and crypto currency trading. The Group's portfolio includes LMAX Exchange, LMAX Global and LMAX Digital.

Bloomberg Tradebook, LLC., the agency broker of Bloomberg L.P., serves global investment advisors, money managers, hedge funds, proprietary desks and broker dealers, with access to global trading venues, proprietary trading algorithms, execution consulting services, pre-and-post trade analytics and independent research. Through a trading platform integrated with the Bloomberg Professional service, Bloomberg Tradebook provides its customers with direct market access to more than 110 markets and global trading solutions for equities, futures, and options across 44 countries, as well as 43 currency pairs. Tradebook offers over 55 proprietary algorithms designed for each asset class and market.

<span class="mw-page-title-main">Robert Almgren</span>

Robert F. Almgren is an applied mathematician, academic, and businessman focused on market microstructure and order execution. He is the son of Princeton mathematician Frederick J. Almgren, Jr. With Neil Chriss, he wrote the seminal paper "Optimal execution of portfolio transactions," which Institutional Investor said "helped lay the groundwork for arrival-price algorithms being developed on Wall Street." In 2008 with Christian Hauff, he cofounded Quantitative Brokers, a financial technology company providing agency algorithmic execution in futures and interest rate markets. He is currently Chief Scientist at QB and a visiting professor in Operations Research and Financial Engineering at Princeton University.

References

  1. ↑ Jeffs, Luke (December 17, 2007). "Brokers doubt forecastsof trading fragmentation". Wall Street Journal . had led banks and brokers ... to offer smart order routing.
  2. ↑ Foucault, Thierry; Pagano, Marco; Röell, Ailsa (2013). Market Liquidity: Theory, Evidence, and Policy. They often use smart order-routing technologies to ...
  3. ↑ Wallace, Anise C. (January 15, 1988). "Stock Exchange sets test to curb Program Trading". The New York Times .
  4. 1 2 O’Conor, Michael (2009-06-03). "Smart or Out‐Smarted?" (PDF). Jordan & Jordan. Retrieved 31 October 2016.
  5. ↑ Network World . October 17, 1988. p. 7.{{cite magazine}}: Missing or empty |title= (help)
  6. ↑ Daly, Rob, ed. (2009-10-05). "Navigating the Future of Smart Order Routing" (PDF). Dealing with Technology Special Report.
  7. ↑ Wennerberg, Christer. "The Evolution of Smart Order Routers: For the European equity markets".
  8. ↑ "Banc of America Securities Announces Smart Order Routing for Equity Options: New Product Supports Best Execution in Derivatives Markets". PRNewswire. 2006-01-24.
  9. 1 2 Cont, Rama; Kukanov, Arseniy (2017-01-03). "Optimal order placement in limit order markets". Quantitative Finance. 17: 21–39. CiteSeerX   10.1.1.245.1411 . doi:10.1080/14697688.2016.1190030. S2CID   14652208.
  10. 1 2 Itkin, Iosif (2011-09-27). "Liquidity Fragmentation & SOR".
  11. ↑ "Stocks for Jocks". Barron's. 2005-04-25.
  12. 1 2 Gomber, Peter; Gsell, Markus. "Catching up with technology – The impact of regulatory changes on ECNs/MTFs and the trading venue landscape in Europe" (PDF). Competition and Regulation in Network Industries (The Future of Alternative Trading Systems and ECNs in Global Financial Markets).
  13. ↑ Itkin, Iosif; Zverev, Alexey; Buyanova, Olga; Klyachko, Dasha. "Advanced SOR Testing: Addressing the challenges in testing advanced execution platforms" (PDF).
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