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March 1, 2004

Preferenced by Smart Routers

By Kim Bang

The traditional market making business model of internalizing order flow and taking the spread is obsolete. As a result of regulatory intervention, the OTC marketplace has become more competitive: ECNs provide more transparency and direct access, decimal pricing has led to narrower spreads and SuperMontage allows auto-execution of dealers' quotations.

Automated execution facilities serve both retail and institutional clients.

Retail order flow, because of the lack of profitability of internalization, was the first to become auto-quoted/routed into the NMS. Institutional order flow is also auto-processed by breaking down large block orders into smaller, retail-sized' orders and slicing them into the open marketplace. In fact, quantitative programs and institutional benchmark trading strategies now represent nearly 50 percent of all transactional volume.

All of these automated execution systems all depend on smart routing logic to seek liquidity and best execution at the lowest cost. The adoption of smart routers by dealers, exchanges and ECNs is a relatively new phenomenon. The last of the large internalizers has only recently thrown in the towel on internalization, realizing that, in a fragmented, decimal spread, auto-execution marketplace no one stands alone. In order to access liquidity across a fragmented market place, smart routing is necessary.

Understanding how these smart routers are configured can help market professionals gain an edge when selecting a trading venue in pursuit of a superior execution. The NMS is fragmented among a number of competing liquidity venues - including Archipelago Exchange, the ADF, Nasdaq SuperMontage and several ECNs - so it is important to understand how these venues compete to attract order flow. It is also important to know how they are preferenced by smart routers.

In a rapid-fire marketplace, where smaller order slices are constantly being smart routed, the objective is to position your trading interest in front of as much of that order flow as possible. Smart routers basically examine these factors when determining which liquidity venue to preference first:

* Price Looks for the best price and routes the order to that venue.

* Access Fees If the same price is available on several venues the order will be routed to the one that charges the least. Unlike a central limit order book (CLOB), where equal prices are executed in time priority, the NMS has competing quotes and market participants can choose who to send their order to first.

* Size of the order (display and reserve book) If the same price is available from two or more venues that charge the same liquidity access fee the order will be routed to the venue that is most likely to fill the entire order. Single counterparty executions are better than multiple, because they reduce the number of trade tickets and clearing charges.

Smart routers examine these factors when determining a liquidity venue to initiate (place) a bid or an offer:

* Where is the order most likely to get traded at the bid/offer limit price? When a resting bid/offer is executed, the spread is successfully captured, which could be several cents savings, and no liquidity access fee is incurred.

* Where is the order most likely to get executed quickly, minimizing opportunity cost?

* Where is the order most likely to get executed in full so as to minimize market impact?

* What venue pays the largest rebate?

For those in constant pursuit of superior execution results at the lowest cost -- both explicit and implicit - finding the liquidity venue that gets preferenced first by the smart routers is critical. That liquidity venue will charge the lowest liquidity access fee and has the largest orders (display and reserve). When you place your orders in this venue, you may be executed ahead of others quoting at the same price, your orders may get executed when others' don't, and you may buy and sell more stock on the bid and offer, thereby achieving a superior execution.

Kim Bang is President of Bloomberg Tradebook.