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May 16, 2007

Smart Gets Smarter

By Nina Mehta

In addition to recognizing top-of-book and exchanges' various rules, a smart order router must know that NYSE Arca, for instance, permits various kinds of tracking, Holway says. An algo buying stock can have the exchange track its orders on the bid plus a penny or track the primary market, or always bid a penny below last sale. He adds that figuring out when to use which order type and how those decisions might affect other market participants' behavior is a challenging puzzle.

Goldman Sachs has spent "millions of dollars" over the last few years on its effort to expand and tailor its order-routing logic in the face of a shifting trading environment, Hale says. She adds that this effort supports Goldman's algorithmic offerings as well as the firm's overall ability to trade in the markets.

Size Matters

In Hale's view, being a large broker is now key to getting better executions. "You can only slice and dice orders in certain ways, and everyone can do that well," she says. "At every level, knowing when, where and how to place an order in the marketplace is increasingly a competitive process, and having access to unique liquidity generated by strong market share is what separates people at this point."

Commanding a larger market share increases the order and execution data a firm can analyze, enabling it to fine-tune routing decisions and potentially improve its executions. Hale notes that given the financial and technological investment now required, "I can't see how a player that's 10th or 15th in algorithmic executions can compete against the top three."

Executions are becoming more complex for several reasons. The quote-protection rule ensures that brokers will establish fast, low-latency connectivity to every market with protected quotes. Latency itself is a new competitive front that is increasingly important (see sidebar).

In the new Reg NMS environment, liquidity will go to the best protected quote. The number of exchanges and ECNs has already increased as market players saw opportunities to compete with established trading centers on the basis of price rather than relationships, history and habit.

Under Reg NMS, if an exchange receives an order that would otherwise trade through protected quotes on other market centers, it must route out a sufficient quantity of the order to satisfy its quote-protection obligation. However, that routing to the best price adds a slight delay in the execution and subjects the broker to the exchange's routing decisions.

Most brokers that value fast access to liquidity expect to control their own executions. They do not plan to rely on exchanges to route orders to better-priced markets. They will instead use smart order routing and a new order type called the intermarket sweep order, or ISO, to grab those protected quotes themselves.

Exchanges now make two new sets of decisions that could affect the quality of algorithmic executions. Exchanges dictate how they route orders to market centers with protected quotes when those protected quotes are at the same price. For example, an exchange could decide to route to a stock's primary market, to the venue with the cheapest execution costs or to the market with the deepest liquidity. It could also split the order and send it to different destinations.