KYB – know your broker vs the order routing enigma

To judge the efficacy of smart order routers buy-side traders are urged to stay on top of brokers

"How many of you, based on data flow, expect positive commission flow – or are brokers making money off your flow?” John Greenan, global multi-asset connectivity manager, BNP Paribas Fortis Investments, asked, summing up a session on how to judge the effectiveness of smart order routers.
Opening with Deep Throat’s exhortation in All the President’s Men to “follow the money”, he offered three efficacy tests. The first uses consolidated data supplied by the broker, broken down by market index and ADV bands. “At least simple statistics on broker and venue, with standard deviation, show you what they’re doing with your flow,” he said. A second and more sophisticated plan involves sector-based benchmarking. Traders use their own OMS to support Tag 30 on executions and gather their own data in-house. Those choosing this option must be prepared to normalise the data – to treat it in-house by placing identifiers on it for brokers, for example. The third, ‘gold-plated’ solution offers depth of book for every venue – including every parent order sent to the broker, every child order – and cancellation – the broker sends to the venue.
“The pursuit of perfection is costly and perhaps inappropriate for many buy-sides,” said Greenan. “On the other hand, vendor-supplied solutions may store some data but not clean it up and make sensible analysis out of it.”
The message was simple: know your brokers – and keep on top of them. “Question brokers. It isn’t something you do every day but it needs to be part of the quarterly, half-yearly or annual review,” said Huw Gronow, head trader, Principal Global Investors.

Broker selection

“Where brokers execute and where they have the capability to execute are completely different questions,” noted Greenan in response to an audience question on latency. “The amounts spent on low latency systems are vast but an easier starting point is to ask where the broker did execute, rather than where they could execute.”
The lack of a state-of-art smart router won’t necessarily rule out brokers, despite the MIFID requirement for best execution. “But you could see it as an extension of buy-side due diligence whether brokers have a router or not,” observed Greenan. “You could use those without as niche or speciality brokers and exclude them from certain elements of your flow.” Ayn Rand’s dictum – “Men have been taught that it is a virtue to agree with others; the creator is the man who disagrees” – raised the possibility that the ‘right’ broker may in fact be the outlying one.
“That’s for buy-side to determine,” said Greenan. “All of us have to think about how we interact with the market and how we trade.” Likewise, despite the dominance of big banks with sizeable technology capacity, small operations – such as those with a specialism in small-caps or expertise in liquidity – still have something to offer, he said.
Widespread adoption of smart order routers begs the question: so what happens if you – or your broker – routes orders the old-fashioned way? Not much, acknowledged Gronow. After all, there has been little measurement to date – and what you don’t measure you can’t manage. The real loss will be in terms of opportunity cost. “These trades are very hard to measure. Smart order routing gives you the potential for a better price for the trade,” said Gronow.

Coming storm

In the meantime, the proliferation of dark pools and vigilant regulators make further regulation almost inevitable. Given the opportunity to regulate, regulators are unlikely to stand back and leave well alone. “The political will is there to regulate at the moment. Regulators, having got a sniff of this, are looking to regulate,” said Greenan. “The SEC might feel brokers are not very transparent. The question is what they’re going to do about it. Dark pool flow is much less here than in US but any proposals brought in the US will have an impact in the EU.”
“The volume of regulation will go up and we, as an industry, will have very little impact on that. Bashing the banks is the new black. Don’t try to argue with a storm. More regulation is coming: get used to it.” 

Quoted from the original published in 20th April 2010.  Compare with the excellent article "The order routing enigma" by Hayley McDowell in The Trade - the abstract reads "The majority of brokers do not provide the buy-side with full order routing transparency. Hayley McDowell asks whether the buy-side should be probing their brokers to find out where unfilled orders are being sent."
Was that original piece really from 2010?