As buyside traders hit the send button, they can take comfort in the fact that their orders are flying out at the speed of light. But to where? To an exchange? A dark pool? How many venues does that order hit before it actually gets filled? And more importantly, who sees the order, and is there leakage of information that could negatively affect the price of the stock for the buyside?
Trading algorithms and smart order routers have given the buyside increased control over their orders, but now many on the buyside want more information. They are asking what happened to their orders before they got filled. And if they’re being exposed to toxicity in certain venues, they want that to stop -fast.
What’s at stake? A lot. According to Kevin Cronin, global head of equity trading at Invesco, it is necessary to know where your orders are routed to fulfill your fiduciary responsibility as a money manager. That’s because the way brokers route orders may or may not be consistent with what is best for clients, said Cronin, whose firm runs $271 billion in equities worldwide.
The current lack of transparency poses a problem, say many on the buyside.
"We get some data on order routing but would like more data and transparency regarding this process," said William Quinn, senior equity trader at San Francisco-based money manager HighMark Capital Management, which manages $5 billion in equities.
Other buysiders said the same thing. Dennis Fox, head trader at Munder Capital Management in Birmingham, Mich., said he gets some information about where his orders go. But it is not enough for him and his firm with $16 billion in assets. Fox wants greater clarity about his brokers’ routing practices. And the sellside is keenly aware of this demand.
"Clients are wanting to know more and do more," said John Goeller, managing director within global execution services at Bank of America Merrill Lynch. "They’re becoming more sophisticated. It’s a natural evolution."
For their part, brokers are flexible to client demand. They can route orders to certain venues first, and route to other venues not at all. But Goeller said it’s a function of asking. It can be difficult to show empirically that information leakage is coming from a particular venue, so if the buyside suspects they’re being gamed, they have to speak up, he said.
Goeller and others on the sellside often welcome questions about a trade, since those queries provide a chance to ensure that both the broker and the client are on the same page. He knows that there’s often an important subtext when customers ask about order flow. They want to know what brokers did with their orders, but they also want to know that the broker is someone they can trust.
"Ultimately, it’s about whether brokers are routing order flow for their benefit or for the client," Goeller said. "Is the broker routing to an exchange for their economic benefit, or are they routing to the exchange which provides the best execution?"
Best Ex or Best Price
While the buyside wants best execution, the sellside wants to keep costs to a bare minimum-which often means routing orders first to their own dark pools, and only as a last resort sending orders to exchanges and paying fees. This has the potential to pit the interests of the buyside against those of the broker.
Invesco’s Cronin said that when brokers prioritize how to route orders, they look first and foremost at economics.
"This business is about managing conflict and this is a conflict we have to pay attention to," he said. "I’m absolutely concerned where my order goes."
In Cronin’s view, brokers will send orders first to dark pools and give preference to their own systems, which cost nothing. Then if an order requires further routing, it goes to the venue where the broker gets the most favorable economic outcome. This is where a potential conflict of interests can arise – is the best price for the broker taking precedence over the best fill for the client?
"If you’re a firm that has seen its commissions squeezed, then you as a broker are going to consider the economics of getting the rebate very carefully," Cronin said.
A recent study by Pragma Securities found that routing behavior is influenced by fee structures, with brokers tending to prefer cheaper venues when price is held equal.
David Mechner, chief executive officer of Pragma, said buyside firms are trying to get more transparency given that a broker’s agenda might not be perfectly lined up with their own.
Such concerns have been heightened in the post-Pipeline world. Last October, regulators alleged Pipeline Trading Systems failed to disclose that at times more than 97 percent of orders in its dark pool were filled by a trading operation affiliated with the firm. While the firm settled the charges last year, buysiders remain cautious as to where their orders are going and why.
"Especially after the Pipeline incident, people are reminded of the fact that there’s not a lot of transparency," Mechner said. "Things are not always well just because they’re out of sight and out of mind."
Part of the problem is that as brokers shop around for best price, an order can be exposed to multiple venues. That increases the chance the order will be pinged by high-frequency traders, creating the potential for information leakage and slippage in price.
Jeff Estella, investment officer and senior equity trader at MFS Investment Management, said at the 2011 Investment Company Institute Equity Markets Conference in December that with orders heading to multiple destinations, HFTs and others can prey upon large orders and undermine best execution.
"That’s the last thing any of us wants to happen," he said. "We ask the broker for more information on the routing logic and venue analysis."
Dancing in the Dark
Even when a venue demonstrates some toxicity due to gaming, Estella warns that simply dumping that venue might not always be the correct approach.
"The problem is that the order flow is fluid," he said. "It may have just been two bad actors in each of these venues, and we need to make sure it was not a naive decision to give a scarlet letter to Venue X."
According to Joe Mecane, a senior executive at NYSE Euronext, the topic of order routing is very prevalent in the equities market now.
Mecane said many on the buyside have been trying to understand not only where their orders are being executed, but also where their orders are going and not being executed.
Part of the reason for the focus on order routing has to do with the growth of dark pools. Dark pools have provided a private place to trade where large orders can be easily concealed when compared with the public exchanges.
However, high-frequency traders have been increasingly present in the darker venues, according to Mecane. "Most of the liquidity in dark pools comes from the HFTs," he says.
Rosenblatt Securities, which tracks dark pool volume, said in its latest report that year-over-year the amount of trades executed in dark pools fell about three-quarters of a percent.
Rosenblatt reported that when combined, dark pool and exchange dark volumes are 15.3 percent of U.S. equity trading.
Justin Schack, managing director for market structure at Rosenblatt, said his firm has been urging buyside clients to get more educated about market structure generally and more specifically about what happens to their orders after they hit the send button.
"The role of the buyside trader has changed a lot," Schack said. "Years ago they were regarded as glorified order takers. They would get the order from the PM and just outsource the execution to the sellside. Now what’s happened is buyside traders have a lot of electronic tools on their desktops, and there is an illusion of control."
Electronic tools such as algorithms and smart order routers can break up trades and send them to different venues, but the exact path a trade takes can still be opaque for the buyside. Traders feel in control, because they get to decide which tools to use, and trade-cost analysis can help them evaluate how well those tools work. Still, the way in which the tools work usually remains a mystery to the trader.
Buysiders today want more than just TCA. It isn’t enough to know the end result of a trade. They want to know each step an order took along the way to execution. That way, they can be sure there are no weak links in the chain where information leakage could occur.
"If execution was favorable, it’s not a problem, but that does not mean it won’t generate questions while evaluating the execution, good or bad," said Craig Jensen, principal and head of trading at Armstrong Shaw Associates, a New Canaan, Conn.-based firm that focuses on large caps and has about $3.4 billion in assets under management.
Schack said buyside traders can do themselves a great service by more closely tracking orders. It can be important to know not just where a trade was executed, but also why it was executed in that venue and what the economics associated with that execution were.
Recently, buyside firms have taken more initiative, and made it clear to the sellside that this information is important to them. It can be easier to get such information now, though getting it is still not easy, he added.
"There are a lot of inconsistencies in the way individual brokers keep track of some of this information and present it," Schack said. "Do they do it in real time as opposed to end of day? Are they able to produce for you all of the hops along the path to execution, all the different stops your order took at various venues where it went unexecuted?"
Some of the big brokers are doing this now, Schack said, but others aren’t, or are only providing the information for certain customers.
Brian Fagen, head of North America execution services sales for Deutsche Bank, said there are different levels of engagement with buyside clients. Some clients really don’t care about order routing. Others are interested in it, but only superficially. Then there are some clients that are very interested and actually take data off of FIX Protocol messages and build processes to track where orders get routed.
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Deutsche Bank has its own internal system known as Trade Pad that can show in real time where executions are occurring, what size they’re occurring at and where price slippage is happening. While the application displays what is going on with an order, the firm’s smart order router automatically recalibrates itself to move away from toxic venues.
"Right now, it’s only internal, but we’re working on making it more of a client-facing application," Fagen said.
Since Deutsche Bank doesn’t offer its own execution management system, it would likely partner with a vendor to stream routing information directly to clients. Fagen said he hopes to have a client-focused version of Trade Pad out by the end of the year.
Currently, it is fairly rare for the buyside to get detailed execution data. According to Alex Hagmeyer, vice president in analysis firm Markit’s data analytics and research group, while brokers usually are able to provide certain routing data in FIX Protocol, they generally do not do so unless the buyside trader asks for it.
"Over the last 12 to 18 months, larger institutions are looking for this information," Hagmeyer said. "Brokers are much more commonly able to provide Tag 30, or last market code, but not by default."
FIXing the Problem
Even when brokers do provide information about where orders get routed, that information is not available to the buyside in a standardized form. The FIX Protocol Ltd. Americas buyside working group is trying to change that. It is considering the adoption of new FIX tags that could provide additional information on orders-and in the same format regardless of the broker.
Brian Lees, an associate vice president and software development manager at Capital Group Companies and a member of the FIX working group, said there are a few tags that could be added this year that might improve the ability to track orders.
"Brokers were making up their own codes," Lees said. "It becomes a never-ending battle of trying to keep up with all of those things. What we needed was a standard way of defining them."
Some brokers are using coding from the International Standards Organization. The ISO established market identifier codes – MIC – in May 2003. According to Hagmeyer these codes are not employed universally by all U.S. brokers, and certainly not on a global scale.
"I can verify the fact that using MIC codes in the FIX Tag 30 has not been adopted by all brokers," he said. "We receive several execution reports with values like ’19’ or ‘N’ in the Tag 30 field. Obviously, neither of these are MIC codes."
That makes order tracking a painstaking process for the buyside and for firms like Markit that provide mapping of the codes and other analysis services.
Lees said many buysiders in Europe want a somewhat different approach to standardized FIX tags than that taken by their U.S. counterparts, and FPL will have to merge the U.S. and European views to come up with a single set of guidelines. Sometime after the first quarter, however, the organization might come out with another addendum to FIX Protocol.
David Lewis, the head trader for U.S. stocks at Franklin Templeton, said that meanwhile there are still things the buyside can do to better track orders with the information they’re getting now.
For instance, firms can look over a long period at which venues actually tend to fill orders. These are the venues that have true liquidity, and if a dark pool is unlikely to execute an order, there’s no reason to send an order there, he said.
Still, there would be a definite advantage to knowing each venue where an order is sent. If firms could better track order flow, they might be able to pinpoint where leakage occurs and make sure they avoid those venues.
Identifying the one step where an algorithm goes wrong could allow firms to tweak an algo rather than discard it entirely.
"I have more than one example where I’ve been using a particular algo and it’s been working great for six months, becomes my top algo, and then it stops working the way you expect it," Lewis said. "The stock starts moving against you, and you can’t figure out why. You stop using that particular algo. You move on to another one. That one works for a little bit, and then all of a sudden, it stops working."
Sometimes the problem is that one of the venues used by the algo has become home to a predatory HFT who has been able to detect a signal on a big order. If that’s the case, and the trader can identify where the signal is coming from, he or she can work with the sellside to modify the algo and avoid that venue.
Lewis said improved transparency will help the sellside and the buyside come together with greater clarity on where leakage might be occurring and shut off those venues rather than having to scrap an entire algo.
Markit’s Hagmeyer said certain dark venues have a larger concentration of HFT presence than the buyside might realize. He added that the sellside has been working with the buyside to limit HFT dark pool penetration.
One way to do that is for dark pool operators to institute a minimum order size constraint for dark orders. This discourages HFTs, who usually post small-share orders to sniff out flow from larger institutions. Markit has looked at price reversion-the way a stock moves back toward a desired execution price after the order is filled-but Hagmeyer said that is not necessarily an indicator of HFTs.
"It could be an indicator that you’re trading with a more informed counterparty-not just HFTs," he said. "However, using a simple price reversion measure is not good enough because other market dynamics can cause a price reversion that is not related to the presence or absence of the client order."
Morgan’s Problem
Morgan Stanley has been pressing the Securities and Exchange Commission to consider mandating that brokers give their customers quarterly reports detailing how they route orders. Any report would include the name of the trading venue, where the order was sent, where it was filled, all the venues the order was routed to and the level of fill rates at each venue.
The firm’s concerns are shared by the buyside. The Investment Company Institute told the SEC in a letter last year that the regulator should "consider means to require new disclosure or to improve existing disclosure … regarding the order routing and execution practices of brokers and trading venues."
Morgan Stanley’s biggest problem is with the dark pools. In a paper it presented to the SEC on March 4 last year, the firm stressed that brokers route to dark pools in order to avoid exchange fees. It estimated that a relatively large brokerage, trading 100 million shares per day, could save $70 million per year routing to a dark pool rather than to an exchange.
That’s a lot of scratch.
Such routing practices are at odds with a broker’s duty to provide best execution, Morgan contends. Because some dark pools probe other pools or allow probing by traders, their usage can result in information leakage. That could cause price moves and hurt the buyside.
Andrew Silverman, global co-head of Morgan Stanley Electronic Trading, said different clients have different needs. Firms should look at how clients trade, as a venue might be perfectly appropriate for one client, but less appropriate for another.
Morgan Stanley does a toxicity analysis on different execution venues, Silverman said. If a client wants Morgan to dig down into its particular order flow, the firm will do that, too, he added.
Like many large firms, Morgan Stanley maintains complete control as to where an order goes. If it’s not filled at one venue, the order goes back to the broker directly for rerouting.
"Under normal market conditions, our liquidity taking orders are sent as non-routable," Silverman said. "We don’t use the routers of market centers because we want to maintain control of our customer’s order."
Morgan Stanley also offers its own dark pool, MS POOL, which attempts to discourage HFTs by giving priority to orders with a larger size over smaller orders at the same price, even if the smaller orders arrived first.
Of the dark pools tracked by Rosenblatt Securities, MS POOL currently ranks sixth in terms of total volume. Silverman said the company is comfortable with the size of its pool, just as it’s comfortable with limiting the number of venues to which it routes orders.
Sometimes, a trader might want to get a trade done as quickly as possible even if leakage potentially impacts price. For Morgan Stanley, however, the quality of execution is more important, Silverman said.
It’s the same at Barclays Capital, according to Bill White, who heads the firm’s electronic trading effort. Quality of execution and getting the highest possible fill rate are the basis of the trading strategy for the sellside firm. Price or cost is "never" a factor in deciding how or where to send a client’s order, he said.
When the buyside comes to Barclays and asks where an order went, White said he’s happy to tell them.
"I love when a client comes to me and asks what my routing process is," said White. "For me, it’s a selling point of our franchise and I have no concern, as I know what they are looking for."
White consults with clients who execute orders with Barclays to show him pre-trade just what the execution strategy is. Then post-trade, he lays out the specific path of the actual order and why it went where it did. "I’ll show them that we executed the order accordingly," he said.
And that is what the buyside is asking for-a little more information about what happens to an order after they hit send.
