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May 16, 2007

Smart Gets Smarter

Smart Order Routing Gets Supercharged in the New Trading World

By Nina Mehta

Smart order routing, a technology that debuted in the Nasdaq market in the late 1990s, is being overhauled and revved up for the Regulation NMS era. Brokerage firms are spending millions of dollars and countless man-hours to update a tried-and-true workhorse of automated trading for a more complex and data-intensive trading environment.

Smart order routing has been overshadowed in recent years by its sexy cousin-the algorithm, which slices orders into the market. Now, no algorithm can afford to go it alone. Algorithms must rely on the smart order routing that underpins their executions to get their orders into an increasingly fragmented marketplace.

"The smart router is being raised to a new level of importance," Jana Hale, global head of algorithmic trading at Goldman Sachs, tells Traders Magazine. "It must decide where an order should be across many exchanges and markets, based on how executions are likely to play out in those markets over the near term."

The rules of engagement have changed. There are now more trading venues, more order types, more competition and new rules dictating the routing priorities and procedures of trading centers. New Reg NMS-prompted exchange-execution rules and order types have led to tremendous uncertainty about how traders should execute orders. Simply routing an order to an exchange for execution is no longer a safe option.

"In the good old days, three months ago, it was much easier to algorithmically send trades down to the floor," says Michael Rosen, a market structure expert and product manager at agency broker UNX. "An algo could just grab a quote and didn't have to worry about little funky things like every exchange having different rules for executing an order. Everything is now much more complex."

Behind this shift is Reg NMS's new quote-protection rule, which requires that the best electronically available bid or offer in each market be protected. This means no exchange or broker can trade through-execute an order at a price inferior to-a protected quote, wherever that quote resides. The rule went into effect for exchanges on March 6 and will become operative for brokers, for a pilot group of 250 stocks, on July 9. Full implementation takes place in October.

Order Placement

The new world of smart order routing concerns what some describe as the "minutiae" of how orders are placed into the marketplace and how a broker tries to aggregate liquidity. Smart order routing is necessary for algos and direct market access. Most brokers have a single smart order router underlying their many algos.

The router determines the best way to get the executions the algorithm wants. Algorithms decide how to slice "parent" orders into the market to try to achieve a client's execution benchmark. Based on mathematical formulas, algos decide how quickly to execute the order, how many shares to execute at a time, how often and at what price. The algo's smart order router then decides how those "child" orders should be placed in the market and how to efficiently take or post liquidity.

This process has become far more complex and less linear as order types and trading venues mushroomed. Many more variables must now be taken into account.