Even before coming into force on 1 November last year, the Markets in Financial Industries Directive (MiFID) had become a catalyst for change in the financial markets. The anticipated abolition of concentration rules introduced the concept of competition between trading venues in many European markets. Furthermore, the advent of the MiFID best execution requirements calls for financial institutions to define an execution policy that explores a variety of trading venues in search of liquidity and best prices. As a result, over the past two years the directive has become a strong determining factor for all trading technology purchasing decisions.
While MiFID certainly created a new regime in the European marketplace, it also provides additional scope for firms to seize competitive advantage. Brokers now need to demonstrate an execution policy customers can trust. For sell-side institutions this is a chance to be differentiated based on their execution policy and compete effectively in the market. For buy-side institutions, this creates an opportunity to differentiate between brokers and secure the best service.
By offering an automated means for brokers to match orders with suitable trading venues, smart order routing (SOR) is key to achieving MiFID compliance and providing competitive advantage. In fact, for most, SOR has become synonymous with best execution.
More Than a Panacea
For many large sell-side institutions with high volumes of electronically routed business, the role of SOR in connecting to every trading venue is already more than a matter of achieving compliance. It is part of an arms race to dominate the market by investing in the most sophisticated SOR solutions.
Smaller players, on the other hand, are gradually becoming aware of market fragmentation. To comply with MiFID and be competitive they will also need to access the new trading venues via SOR services. There are a number of available options for these brokers who wish to connect to multiple trading venues. Some may opt for their own SOR engine in order to access their chosen venues directly or via DMA routes. Others may decide to leverage a B2B relationship with a larger broker to outsource their execution, which is most common for cross-border or non-core business. This creates a mutually beneficial arrangement, whereby larger brokers can offset the cost of their technology investment while smaller players gain access to premium services.
An advantage of using SOR technology for all brokers is that it enables them to carry out arbitrage across multiple venues. Brokers aiming to distinguish themselves can do so by seizing opportunities listed at new trading venues or in dark pools. As the market becomes faster, speed of accessing these new trading venues also becomes crucial. Participants need to be able to access liquidity before their competitors and refresh their prices in real time. As a result, trading platforms need to achieve the lowest possible latency levels.
Furthermore, with SOR, brokers can optimise trade performance across all types of flow – from algorithmic flow to the posting of resting liquidity on dark pools. Brokers can use similar technologies to route multiple trading flows – including smart DMA, algorithms, direct strategy access (DSA) and care flow, through the same channel to achieve best price.
Ultimately, the quality of a broker’s execution policy will be down to the sophistication of its SOR technology. In reaching for the best vendor solution, sell-side firms should consider offerings that bring together multiple, low latency market data sources into one consolidated platform with smart order routing and virtual market view capabilities.
Buy-side Benefits
MiFID may be a headache for the sell-side, but the buy-side certainly stands to benefit from recent market changes – not least because the additional fragmentation caused by MiFID promises to create a wealth of new trading opportunities. And, although aimed primarily at sell-side institutions, SOR also brings advantages for the buy-side. The most obvious of these is that it improves the quality of execution delivered. And it also makes it easier for the buy-side to differentiate between brokers.
Buy-side firms are now being offered smart DMA and other algorithmic services and as they become more sophisticated, they will be able take advantage of these services in accessing liquidity on numerous venues via their brokers.
The Future of SOR
Multilateral trading facilities (MTFs) are currently driving innovation that will affect the buy- and sell-sides, providing members with a strong incentive to post passive flow by creating price advantages for any financial institutions that post their liquidity there. Smaller price increments (providing a much larger number of decimal places), allow traders to’get inside’ the inside prices listed at other venues, thus maximising their chances of trading via the SOR engines. Other examples of innovation include MTFs operating linked dark and published liquidity pools.
Effectively, the evolution of SOR technology will be determined by the idiosyncrasies of these new trading venues and the way the financial institutions interact with them. Each trading venue demands a different set of SOR logic in order to optimise trading opportunities on that venue. This way, SOR will evolve from simply splitting orders to become a much more sophisticated algorithmic mechanism resolving the best trading opportunities across multi-dimensional dark and published liquidity pools – intelligent liquidity access.
In terms of MiFID itself, new benchmarks and methods of measuring best execution may well be introduced in the future; however, financial institutions should not focus too heavily on these issues. As the market fragments, metrics for judging the power and efficiency of SOR technology will develop, and financial institutions will focus more on the quality of the SOR solutions they use. For the moment, performance is the key driver as it allows brokers to set themselves apart by securing liquidity and best prices as quickly as possible.
Eventually, the marketplace and technology changes resulting from MiFID may well precipitate a shift in the relationship between buy- and sell-side. There is a possibility that market evolution will result in technology moving up the chain, with the buy-side investing in its own SOR systems. This does not mean that the role of broker will become obsolete. While the buy-side is becoming more eager for market visibility, there is still a considerable wealth of trading experience and expertise that only brokers can offer – and that few sell-side institutions would care to forego. However, brokers will need to invest heavily in SOR technology in the near future and develop the most advanced algorithms to outstrip the competition and satisfy customer demand.