Smart Order Routing (SOR)
From Revolution to Evolution in the Search for Liquidity and Alpha
Smart Order Routing (SOR) has ebbed and flowed as a topic of interest in the financial industry. Because the functionality has become commonplace in the market, its presence in institutional trading platforms has nearly become an afterthought. But its necessity is without doubt, especially in light of the exponential growth of electronic trading, proliferation of order types and instructions, and fragmentation of liquidity.
The launch of the first smart order router was a revolution in trading, allowing traders to access liquidity across multiple markets and get size done. Independent smart order routers addressed intermarket linkages years before regulatory changes made this a requirement. Early movers in the smart order routing space grew tremendously as a result of their pioneering work. In this early stage, the existence of the tool alone was a large part of its advantage.
With the advent of Reg NMS, smart order routing became a regulatory requirement. Now ubiquitous, smart order routing was no longer a standalone differentiator. Within the brokerage community, focus moved from getting fills to reducing costs.
As competition intensified, routing charges reached a low point for aggressive (spread-crossing) institutional flow by employing virtually every method in which a smart router operator could conceive to reduce execution fees. The stage was set for a change in the industry conversation.
Prompted by new ideas and voices about smart order routing techniques, the industry began to critically examine the functioning of smart order routers. Questions were raised about how liquidity was being accessed to deliver results, and consideration given to the means by which dark and lit pools were used and accessed. Smart order routing methodology moved back to the foreground for customers.
Whether one agreed or disagreed with the arguments in the discussion – certainly, the issues involved are quite complex and difficult to measure – the critical change for the industry was the added pressure on technology and brokerage providers to explain how their products work and defend their implementation decisions. Choosing the lowest explicit cost method was no longer enough.
SOR At a Crossroads
Today smart order routing is at a crossroads. Cost remains an important consideration, but the details of performance and how trading results are achieved have been restored to their rightful place as equally important considerations.
Brokers have multiple options available to them for smart order routing and need to consider whether the available options fit the broker’s business and customers. FlexTrade finds an increasing number of clients (buy-side and sell-side) interested in controlling their smart routing technology with an eye towards delivering optimized results.
Smart order routing is also particularly important in foreign exchange, considering the over-the-counter nature of trading. In FX, choices about connectivity, book building and routing are vital to achieving an optimal trading result.
The decision to invest in smart order routing technology requires firms to consider how deeply enmeshed they should become in managing their smart order routing. This includes firms which have decided to rent their technology from third party providers and firms that have made the investment to build it themselves.
Relevant questions to ask include:
- Improved customer results – will customers receive improved trading results with new smart routing technology, as measured through TCA?
- Lowered execution costs – can the technology reasonably improve (or maintain) the trading expense profile for liquidity taking order flow?
- Lower operating expenses – can the technology operate efficiently, considering costs for hosting, telecom, development and operations?
- Revenue risk – for brokers that rent technology – without proprietary technology, will customers continue to perceive the broker as a differentiated counterparty?
- Return on investment – do the combined answers to these questions result in either improved performance or lowered operating expenses, relative to the cost of the project?
How FlexTrade Can Help
FlexTrade has experience designing and implementing smart order routing technology with clients across asset classes and geographies, and is used extensively in equities, FX and options. Our software and trading experts assist clients with the critical design decisions required for a successful smart routing implementation. We also have expertise with regulatory considerations, including the creation and storage of required reports and snapshots for Reg NMS compliance.
FlexTrade provides a mature, high-performance strategy server, which abstracts many of the core implementation issues so that customers can begin focusing on trading decisions early in the design process. The framework is capable of supporting a wide range of algorithmic requirements required for a smart order router and runs using C++ on Linux for the highest possible performance.
Infrastructure is another area where FlexTrade has made major investments, operating as close to the market as possible, with a high performance server environment, scalable network, and low-latency connectivity. FlexTrade has a presence in top-tier data centers around the world, with an extensive regional and global telecom backbone, offering the ability to deliver products across geographies and asset classes.
FlexTrade, however, believes that insourcing a smart order routing solution is not appropriate for all firms. The customer must have a minimum scale and sophistication to be able to manage the technology and operational issues. For firms capable of managing this technology, FlexTrade can make all the difference towards achieving a high quality result.