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May 16, 2007

Smart Gets Smarter

By Nina Mehta

Exchanges must also decide how to execute orders once they take out protected quotes on other markets. An exchange could route to markets with the next-best-priced quotes to get the best prices for its customers. It could also just fill an order from its own book, which could potentially result in a lower average price.

UNX's Rosen says his firm advises clients not to send market orders to the NYSE because the Big Board preferences its own liquidity after protected quotes on other markets. "If you send a market order to the New York, and it's at the top with two other exchanges but its next quote is 3 or 4 cents away, you'll get protected on the top but then the exchange will rip down through its book instead of going down other markets' books in an orderly fashion," he says.

More ISOs

Smart order routers that can shift orders around and maintain the best bid or offer in multiple locations are likely to find more liquidity. "Algos that have the capability of maintaining top-of-book in multiple markets will get a larger share of liquidity than those posting in a single destination," says Doug Rivelli, managing director and head of electronic trading at Weeden & Co. The ability of routers to respond dynamically is also critical for algorithms that try to "ladder the book" by posting liquidity at various price increments in the market, he adds.

All of these rules and decisions affect customers' execution quality and must be thought through carefully. "It may be better to be at the top of the book at a secondary location or regional than at the primary exchange at another price level," says Goldman's Hale. "That ensures that if the market is swept [by ISOs], the order will be executed."

The ISO, a subset of immediate-or-cancel orders, is the trader's new power tool. It tells a market center that the broker submitting that order has taken over the responsibility for quote protection. Using an ISO requires a broker to simultaneously route additional ISOs to all market centers with protected quotes that would otherwise be traded through. Every trading venue supports ISOs.

To take charge of their own order flow, most large brokers are instituting a wholesale shift from current market and limit orders to ISO and IOC orders. Most brokers have already begun using these order types to see how they work and to test execution quality across venues under different scenarios.

Some made the change early. Morgan Stanley switched to ISOs for "about 99 percent" of its orders on March 5, says Andrew Silverman, head of U.S. electronic trading distribution. That was the day the Securities and Exchange Commission's new quote-protection rule became effective for exchanges and the NASD's Alternative Display Facility participants. The broker "didn't want to add latency to customers' orders," according to Silverman.

Credit Suisse sends out ISO and IOC orders almost exclusively, Mathisson says. He adds that March 5 was Reg NMS's "big bang" for algorithms. However, most brokers expect the broader changes to occur starting in July, when they must officially comply with the order-protection rule.

Dark Orders