Finra recentlyinformed all of its member brokers that it would be conducting a review of their order routing practices and decisions. While I think that such an analysis is much overdue, it should cause a great deal of consternation among the broker dealer community. In addition to the actual decision-making that goes into firms Smart Order Routers (SORs), the FINRA review will likely dig into each firms best execution policies to ensure that they properly evaluate routing choices. Importantly, this means that research and decisions made by the quantitative developers or traders at firms will need to be documented for best execution review purposes. Firms that use the algorithms and SORs of third party brokers will not be immune; in their case, they need to document how they evaluate both the choice of third parties and how they choose the algorithms and routing parameters they supply to that third party.
If I were at a broker dealer that used third party algorithms, I would be extremely nervous about this impending review. I still have vivid memories of running an algorithm business at Citis Lava subsidiary, which sold algorithmic execution services to broker dealers, and remember quite clearly how cost conscious those brokers were. My client is paying me the same commission, no matter what algorithm I use, so why should I pay more to you was something I heard many times. I tried a couple of times to offer up best execution or more liquidity for your clients as an answer, but that was met by laughter from prospects, and anger from existing clients. I suppose it is possible that brokers are more concerned about their clients performance today, compared to 9 years ago, but I doubt it. The bottom line is that brokers are going to have to defend their choices of providers and the types of algorithms and routing strategies they use. They will need a clearly articulated best execution policy to justify their choices. This must include analysis of all the orders routed by their third-party providers including passive, rebate generating orders and all dark pool access, or they will be vulnerable to a negative outcome of FINRAs review.
FINRA plans to focus on three inter-related questions, which require that brokers have a quantitative best execution policy to answer. From an institutional perspective, the questions can be described as follows:
Inducements: This area is predominantly focused on the question:How did the broker choose HOW and WHERE to post passive orders? This is because, on average, posting passive orders earns rebates from exchanges, with a larger rebate paid to displayed orders.
Cost Based Decision-making: This area is focused mainly on the question:How did the broker choose how and where to route aggressive, liquidity-taking orders? This is because, on average, liquidity taking orders are charged fees from exchanges, with larger costs for accessing displayed orders on the primary listing exchanges.
Conflicts of Interest: This area is focused on the question ofhow the broker chose when to route passive vis a vis aggressive, liquidity taking orders? This question also permeates the two questions above, particularly when the option of posting orders on lower or non-rebate paying markets or taking liquidity on cheaper venues is available.
In all three cases, the type of analysis brokers should produce should document opportunity costs, in addition to the explicit execution costs. This is true for both passive orders that are posted on high-rebate venues and routing strategies that attempt to minimize costs.
Specific suggestions and approaches are described in the more in-depth version of this commentary, posted here: