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New Focus on Order Routing

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By Dan Barnes

Order routing technology is about to become considerably more important as regulators demand greater transparency over sell-side order routing and buy-side best execution obligations.

“We’ve really seen this in terms of higher depth of reporting, with clients saying ‘Give me all the data you can give me and stream it in real time’,” says Mark Palmer, senior vice president and general manager of analytics at Tibco.

In its July 2016 report ‘The US Equity Markets: A Plan for Regulatory Reform’, the Committee on Capital Markets Regulation (CCMR), an independent research organisation, notes that the disclosure rules that apply to US equity markets are severely outdated, as they were implemented in 2000 when stocks primarily traded on the floor of an exchange. It recommended to the Securities and Exchange Commission (SEC) that brokers be subject to enhanced disclosure requirements so that institutional and retail investors can determine whether their broker is getting the best prices for their orders.

At a meeting on July 13 the SEC voted unanimously “to propose amendments to Rules 600 and 606 of Regulation NMS to require new disclosures by broker-dealers to institutional customers about the routing and execution of their orders, and to propose targeted enhancements to current order routing disclosures for retail customers.”

The CCMR report references the allegation, made in the 2014 book ‘Flash Boys’, that the market is ‘rigged’ against investors who are focused on investing over trading. The allegation specifically suggested that client orders are subject to biased execution by brokers, giving an advantage to more profitable high-frequency trader (HFT) customers against the less profitable, but nonetheless worthy customers, such as institutional investors.

Evidence that institutional investors were being misled about their order execution by some brokers came in January 2016, when US market regulator the SEC fined Barclays and Credit Suisse US$154.3 million for misrepresenting how client orders interacted with the broker-dealers’ HFT clients in dark pool environments under the control of the broker-dealers.

Ground truths

According to the SEC’s complaint against Barclays, the firm claimed to provide a level of surveillance to protect client orders which it did not, or that the profiling of subscribers to its dark pool would sometimes be overridden by the bank to re-categorise clients so that “subscribers that elected to block trading against aggressive subscribers nonetheless continued to interact with them.”

Barclays also claimed only to use direct data feeds form the exchanges but actually used other, slower feeds in the dark pool.

“Barclays misrepresented its efforts to police its dark pool, overrode its surveillance tool, and misled its subscribers about data feeds at the very time that data feeds were an intense topic of interest,” said Robert Cohen, co-chief of the Market Abuse Unit. “Investors deserve fair and equitable markets without this misbehaviour.”

Credit Suisse meanwhile was said to have misrepresented the tool for characterising subscriber order flow as “objective and transparent” when it included “significant subjective elements, was not transparent, and did not categorize all subscribers on a monthly basis.”

There was more;

  • that Credit Suisse accepted, ranked, and executed over 117 million illegal sub-penny orders in its Crossfinder dark pool,
  • that it failed to treat subscriber order information confidentially and failed to disclose to all Crossfinder subscribers that their confidential order information was being transmitted out of the dark pool to other Credit Suisse systems [where was not disclosed];
  • that it failed to inform subscribers that the Credit Suisse order router systematically prioritised Crossfinder over other venues in certain stages of its dark-only routing process;
  • And that finally, it also failed to disclose that it operated a technology called Crosslink that alerted two high-frequency trading firms to the existence of orders that Credit Suisse customers had submitted for execution.

Getting better

Regulators are increasingly conscious of the threat to market stability posed by order routing issues and market participants are actively looking for ways to build trust. The CCMR concluded that “The disclosure rules that apply to our equity markets are severely outdated, as they were implemented in 2000 when stocks primarily traded on the floor of an exchange.”

Curtis Pfeiffer, chief business officer at Pragma Securities, says: “In Europe there is MiFID II coming and similar regulations in the US, while the SEC has also fined a number of firms for transgressions, so data storage and transparency of how algorithms are trading will continue to be key components of products and services going forward.”

Understanding how and where an order is traded is fundamental to understanding if the price at which it is traded is a good one. Best execution as a principle is enshrined in European regulation and in US law where brokers are legally required to seek the best execution “reasonably available for their customers’ orders”.

That trust is eroded as legal cases are brought against the broker-dealers expected to provide institutional customers with standardized reports that provide order routing and execution quality statistics. The significance of the reports for buy-side traders depends upon their style of trading and the extent to which they use data.

“People working in my role look at a whole raft of different transaction cost analysis (TCA) measures,” says Adrian Fitzpatrick, head of investment dealing at buy-side firm Kames Capital. “The key is whether you value TCA as a product, in the sense of what you are doing or whether it is more about liquidity. We are very much focussed on liquidity as opposed to TCA analysis because for us the fund managers make a decision and we are part of the investment process, so our job it to implement their ideas. The market is evolving and people will do different things in different ways.”

If regulators mandate standardisation of trade reporting, then traders of all levels ought to be able to quantify best execution more easily.

“The buy-side needs to have greater transparency as to how their orders are being traded in the marketplace, whether that is an order where they have used an algo directly or they have given an order to a high-touch trader who then utilizes an algo,” says Pfeiffer. “At the end of the day investment managers want as much transparency into how their order is executed, no matter what tool or method they are utilising from a broker.”

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