18 May 2009 Features

 

TradeTech 2009: Will smart routing be routed?

Words: Tom Groenfeldt

The implementation of MiFID is still a work in progress, according to delegates at TradeTech in Paris last month. The smartness of order routing systems needs closer scrutiny, while pressure grows for a consolidated price tape.

European equity markets have made progress toward integration and innovation, but they have been hampered by the financial crisis and governments, experts at TradeTech in Paris concluded.  The annual conference drew about as many participants as last year - somewhat to the relief of organisers and vendors who had feared a sharp drop in attendees due to economic conditions. There was certainly a lot to talk about.

MiFID

Topic of the day, the Markets in Financial Instruments Directive has been a partial success according to 54% of the audience in one session who were expressing themselves via the medium of electronic voting.       "It would be premature to say it has not done its job," explained Eli Lederman, chief executive of Turquoise, one of the new electronic trading venues. "It is a success-in-progress with some significant victories in a landscape that had been characterised by inertia for many, many years." Post-MiFID the market has a material amount of competition on cost and it offers different types of trading.

If only MiFID had been launched a year or two earlier, it would have been able to impact the market before the credit crisis, lamented one speaker.  Despite offering lower prices and faster transaction speeds, multi-lateral trading facilities have gained only 25% market share. Lederman said the ratio should be the other way around, with only 25% of the volume left on the older exchanges. "If I were a regulator, I would ask why we are not moving faster because the end investor is losing to the legacy companies." The low share of orders going to venues which are faster and cheaper will end up stifling innovation, said another.

Brian Gallagher, executive director at Morgan Stanley, said that market structures took a long time to begin changing in the US, and then the volume on the New York Stock Exchange dropped precipitously, "Brokers have a lot of work to do to fully embrace the MTFs."

Lederman described the MTFs and exchanges as uni-dimensional, providing faster execution of increasingly small orders trading at high frequency. Marcus Hooper executive director in Europe, for Pipeline, a dark pool provider, cited Tabb Group statistics showing the average order size in the US has dropped to just 200 shares. Lederman suggested that the industry should be looking at different types of trading, such as dark pools and perhaps larger orders trading at lower frequency, rather than just driving for faster executions.

Hugh Brown, head of secondary markets product development at the London Stock Exchange, said MiFID had actually brought greater competition and some benefits. The end customer might not have seen commission rates go down, but they have probably achieved better execution prices, he said. He worried that when faced with innovation the FSA and CESR will focus on issues of price display and reduce waivers for MTFs. This is an opportunity for the industry to reach a consensus and approach the regulators.

Rules and rulers

Several speakers criticised the FSA for not understanding even basic market realities, especially when it comes to issues of pre-trade transparency and the role of dark pools.  Everyone involved in trading thinks fears over dark pools are complete nonsense, said one provider, "How can they stifle innovation with a view of the markets that is driven by the incumbent exchanges? They are protecting the status quo," he said. The current market with lit pools and dark pools leaves a gap which could be filled by innovative venues, "But the regulators won't allow it because they don't understand it and that means the incumbents can maintain the status quo." The inadequacy of the FSA threatens London's role as a financial centre, said several participants. Existing national exchanges and their governments are not thought to be enthusiastic about changes.

Another noted that the UK does not have any rules to coordinate time stamping of trades; every trading venue runs its own time stamping, so it is impossible to determine whether a price was the best available at a particular time. When he raised the issue with the FSA, they couldn't see why it was important, as long as the times were accurate within a minute or two. But as Richard Balarkas, chief executive of Instinet Europe, noted in a presentation at FIX Protocol in London just a few weeks ago, a review of just one second of trading records for Vodaphone showed 72 price changes - in one second - including 11 cases of backwardation, where the offer was cheaper than the bid.

Pre-trade transparency is no good for human traders it seems, because the prices change too fast for them to see; the prices are only useful to smart order routers.  Although MiFID requires brokers to develop a best execution policy which must be made available to clients, there is no enforcement and the policies have such huge gaps you could drive a truck through them, said one industry expert.

Order routing - smart for whom?

Balarkas repeatedly criticised the industry for not paying attention to best execution, pointing out that brokers don't provide the information and buy side firms don't ask for it, begging the question:  how smart are smart order routers? The answer, it seems is that nobody knows. Nigel Coleman, UK head of equity trading at Credit Suisse Asset Management, commented that he would like to know whether a broker is using a particular venue because it suits them or it is good for the client, "Are they inappropriately routing my orders to the cheapest venue for the broker? There's a gap in the market for policing SOR."

Most smart order routers are not doing enough to access the liquidity on MTFs, stated Lederman, "In a year when people look back at "smart" order routing they will realise a lot of it isn't smart at all, and will have to improve when brokers have to explain what SORs are doing with the order. There isn't a basic standard by which investors and consultants can say ‘Your smart order router is best', and a small firm which can't afford to develop a smart order router will say it doesn't matter. It is appalling we don't have the ability for clients. Nor is there a standard method of analysing buy side trading desks which allows them to be compared in any meaningful way."

Issues around best execution and costs - transaction cost analysis - surfaced in a number of sessions at TradeTech.  One MTF manager said that although the basic numbers from TCA are used to measure transaction costs, "they are completely inadequate to the task. That is largely because information on prices at the various venues is not available - neither brokers nor the exchanges and MTFs are providing it."

Coleman said it is time for TCA providers to improve their offerings, "The industry has had it very easy for quite some time. We are all compelled to use TCA because the trustees of clients have been asking for it. The industry has taken a reasonable amount of money out of the fund management industry, we now want them to take it to the next level - I want to know how smart the smart order routers are and we can't do it until TCA vendors look at data from the market venues, and I don't think any of them are."

Christophe Mast, global head of trading at RCM/Allianz Global Investors, said a big missing piece in MiFID is a consolidated tape showing prices across exchanges and MTFs. "We need something like the best price rule," he added. "The SEC has done a much better job. Perhaps that will be good for Phase II. We probably need the help of the regulator and strong relationship management to ensure that consultants and brokers don't pull your leg." BT