The Gateway to Algorithmic and Automated Trading

You want alpha with that?

Published in Automated Trader Magazine Issue 14 Q3 2009

And do you want your order well done, or scrambled? Helen Sanders serves up the latest in adaptive routing technology.

Smart order routing (SOR) technology is part of every algorithmic trader's toolbox. Like so many other things these days, it's not rocket science. It's basic; more like the screwdriver or the hammer than the whizzy new gadget for putting men on the moon. But in a competitive world, there's a limit to how basic your toolbox can be. Just as the humble but favourite screwdriver may end up languishing at the bottom of the box because the latest electric screwdriver with a motor the size of a Mini screws more screws into place more quickly, so the familiar, easy-to-use SOR kit may one day have to be put aside in favour of the even smarter package that not only routes orders, but does it faster and more effectively than the other guys in the market imagined was possible.

Mind you, 'smart' can end up meaning the same thing as 'stupid' if the new solution doesn't do what it says on the GUI, in exactly the way it promises on the GUI, without a dozen calls to the priority-client helpdesk first. There is such a thing as 'smarter' order routing, but there is also such a thing as over-specified, over-designed counter-productive technology that comes with all the bells and whistles but doesn't actually function because inputting anything is about as easy as reprogramming Apollo 11 in mid-flight to land on Saturn's sixth moon. Over there in Automated Trader's storage silo for mixed metaphors, they also have a saying that all the clever little connectors and precision-sized fixings in the IKEA box are just so much junk if the intructions don't mention that you're going to need an allen key to put them together.

As the trading world continues to fragment and traders develop ever more cunning tricks to obscure their actions until after the deal's done, what is important is not to have the smartest tools, but the competitively smarter tools that are, as it were, easy to drive. In some cases, these may be the latest, fastest and most sophisticated solutions, but in others, the answer may be less obvious.

Cheap, cheap

What makes an order really 'smart'?
Are we talking about the scene in the busy coffee bar at commuter time? The yell from the cashier at one end of the counter to the barista demanding a "tall skinny latte to go", her efforts drowned out by the customer who's got her coffee but hasn't found the little wooden paddles to stir in the sprinkles on top? And now wants to buy the souvenir mug as well?
Or are we looking through the window at the busy restaurant where waiting staff have hand-held machines which automatically send their drinks orders to the bar and their food orders to the kitchen in real time? Lots of quiet conversation only interrupted by the incessant buzz of "Is everything all right?"

The cosy little prop shop or the thirty-eighth floor of the megabank?

Point being that technology has to be engineered to fit the market, not the other way round. Apply the restaurant's solution to the coffee shop, and you have an over-engineered, wasted investment, when simply writing the order down on a paper cup and passing it along the counter might do the same job far more cost-effectively. Stitch up those two prop shop guys with a megabank-sized oversight department, and - well, maybe the coffee shop has a couple of vacancies.

Few algorithmic traders are now without smart order routing (SOR) tools, which allow traders to sweep each market and search out liquidity in ever-more sophisticated ways. But just as in a restaurant, the result of up-to-date technology has to be better user/customer service and greater efficiency. Any investment in ugrading these tools has to be the right one, with a clear business justification and the ability to cope with rapidly evolving, fragmenting markets.

Dhiren Rawal

Dhiren Rawal

Showing the Strain

As we all know, technology is usually outdated as soon as we've bought it. It is always possible to find SOR tools which are newer, faster and apparently more sophisticated. But in a cash-strapped environment, how can investment in SOR tools be prioritised compared with other potential investments? SOR tools themselves are, of course important, as Joe Wald, Managing Director, Knight Capital Group (formerly EdgeTrade) explains: "MiFID has necessitated smart order execution tools now that liquidity is fragmented across trading venues. There are clear benefits in sourcing liquidity, gaining pricing advantage and reducing market impact and information leakage."

The problem that many traders have today is that the SOR tools they invested in comparatively recently are already showing signs of strain. Traders also toting the latest iTouch and who are drumming their fingers waiting for the next gaming station to appear on the horizon will probably be delighted at this, but managers whose cheque books are already dog-eared will be less so.

The problem is, as Rob Boardman, Head of Electronic Trading, Europe, Investment Technology Group
(ITG) explains, although most traders now have SOR in place, these tools, which generally originate in the US, are not always fully fit for purpose in the more fragmented European market: "Most brokers have some form of smart order routing technology in place, although this was not the case six or nine months ago. Often this is 'borrowed' from the US, however, and has not been adapted to the nuances of the European market, so it can be somewhat rudimentary."

In particular, MiFID and the liquidity squeeze have placed significant pressure on these tools which were designed during more benign times, so SOR need to be smart to European demands. As Joe Wald, Knight Capital Group emphasises, being able to invest in the right SOR solutions will differentiate between those that will survive and those who will not: "As the market has evolved, so too has smart order routing. The past year has seen MiFID, market turmoil and developers in disarray. Some brokers are simply trying to exist, and will be less able to invest in new tools which will make the stronger firms more competitive."

Rob Boardman, ITG agrees, and heralds the rise of more sophisticated tools for the changing market environment: "As the market has become increasingly complex in terms of order types, trading venues etc. and with high frequency traders appearing in Europe, the demands on smart order routing tools have increased dramatically, so brokers need to be looking at the next generation of smart order routing."

Joe Wald

Joe Wald

Executing at the Oasis

Effective SOR tools are not restricted to large-cap liquidity. For example, Knight Capital Group have recently launched Oasis, a smart order execution algorithm for small- and mid-cap liquidity, which aims to handle trading obstacles associated with thin and difficult-to-trade names. As Joe Wald, Managing Director, Knight Capital Group explains: "We created Oasis as a next-generation algorithmic strategy in recognition of the fact that there are increased overall costs and risks associated with trading small- and mid-cap stocks, such as higher volatility, less liquidity and wider spreads.

Speed Out, Speed In

So the ability to support specific European requirements is one issue, but what else do traders need today from their SOR? One important element in any algorithmic trading solution is low latency, but simply focusing on ever more speed when sweeping the markets is not enough. Equally, or more significant, is the speed with which data on which routing rules are based is brought into the system, and how this data is then used to inform decision-making. As Dhiren Rawal, Managing Director, Quod Financial says: "One of the requirements of the post-MiFID, fragmented market environment is the need to make real-time decisions, not simply to sweep the markets and then make decisions. Real time decision-making is a fundamental part of the new generation for smart order routers."

Joe Wald, Knight Capital Group, concurs, illustrating how a lack of real-time data can skew trading decisions: "While there is typically a reliance on historic information in order to define the routing strategy, this does not take into account the situation of a rapidly growing venue or one with depressed levels of liquidity. Traders need real time data in order to adapt the routing strategy."

To address this, as Wald continues, SOR vendors are taking a new approach to the way in which these tools are used, moving from a linear to an intelligent routing strategy: "In 2005, EdgeTrade coined the term 'smart order execution', which reflected a substantial difference in methodology. While smart order routing is based on a linear approach, in which each market is swept in order, and then the order is posted, the concept of smart order execution looks at where the liquidity is and adapts its routing accordingly."

Dearth of Data

However, even though SOR tools are developing sophisticated capabilities to integrate and respond to data in real-time, one of the implications of market fragmentation in Europe is that the quality of information available is similarly fragmented and variable in quality. For example, without a consolidated "tape" as in the US, traders have to bring together post-trade data from different locations themselves and integrate it with pre-trade intelligence from their own systems. As market and data alignment continues in Europe, this pressure will be alleviated over time, but this is still some way off, particularly as MiFID has impacted some markets more than others so far. For example, in countries such as Spain, there is as yet little change in the trading environment since MiFID but as these markets mature, new fragmentation will occur even when other trading locations are more aligned.

Rob Boardman

Rob Boardman

Plug in and Play

So where does a new generation of tools leave traders who have already made a substantial investment in SOR? Can they avoid these systems being relegated to the cupboard where OS/2, the telex machine and a dusty old Commodore now moulder? Fortunately, yes. Dhiren Rawal, Quod Financial describes how the way in which systems are delivered is changing, with new 'plug and play' capabilities supplementing existing tools, rather than sending them to scrap: "One challenge for traders who have already invested in first generation smart order routers is that they now want to take advantage of newer capabilities without the need for substantial new investment. Such firms are seeking component-based solutions which enable them to take on new tools with as little disruption as possible."

Rob Boardman, ITG advises caution before becoming starstruck by shiny new product brochures, as any new tools need to have demonstrable business benefit: "While a technology may be good, it needs to save money, which also includes opportunity costs." As Joe Wald, Knight Capital Group explains, traders need to factor in the costs across the entire trading cycle, rather than simply the initial trade execution process: "Smart order routing needs low latency and direct connectivity to exchanges. In Europe, it is not only trading venues which are fragmented but also clearing, which makes the trading process more complex as clearing needs to be as cost-effective as possible."

The cost and effort required for direct connectivity can be considerable and is one of the reasons why traders are increasingly selecting third party SOR tools as opposed to adopting a DIY approach. In doing so, traders are better able to "future proof" their investment.

A related approach is to look not only at SOR tools as a way of accessing different markets, but also to implement aggregation tools, for example SunGard's Assent Dark Pool Aggregator, to enable traders to access multiple venues concurrently, while reducing the number of connections required and the costs associated with accessing each of these new venues. Such systems also have intelligent routing to map trading strategies with overall execution objectives.

Looking Ahead

Industry experts seem consistent in their view of how SOR will develop in the future, focusing on the continued consolidation and intelligent use of real-time data, leading to more sophisticated trading strategies. Joe Wald, Knight Capital Group predicts: "Looking ahead, smart order execution will still be fundamental to algorithmic strategies to capture alpha and reduce market impact. We will increasingly see algorithms within algorithms, facilitating more complex trading strategies cross-order type."

Dhiren Rawal, Quod Financial agrees, although he emphasises the need for concurrent developments in the availability of market data to fuel these new tools: "Over time, we see more data being brought into the real-time decision making arena and a higher quality of information. We are already seeing the start of this now, with consolidated data being made available including market data, fragmentation data and TCA data. As more of this information is made available across multiple asset classes, it is likely to lead to the development of more cross-asset trading strategies. Current smart order routing tools make this quite difficult as there is not yet enough real-time data available. The next generation of smart order routing tools will generate near- and real-time information from pre- and post-trade execution flows."

In addition to SOR tools, related tools such as aggregators will become increasingly important, and solutions which combine the two have the potential to be particularly powerful. As Rob Boardman, ITG expresses: "Ultimately, the adoption of ever better smart order routing will come down to a scoring draw, and any advantage will only be temporary."
However, working with the right technology partners, who understand the European market, with evolving solutions and a component-based approach, will go a long way to ensuring that traders make the right investment in SOR and position themselves for future success.