The (Smart Order) Route to Best Execution

The enhanced reporting requirements of MiFID II and the potential for a resultant proliferation of new execution venues present a considerable challenge to sell side firms and their best execution technology. Specifically, this has big implications for the order routing aspect of an execution strategy.

Increasing market fragmentation across the globe has meant that the Smart Order Router (SOR) is now a vital part of any execution strategy. And its role is set to become even more critical in the next 12 months, especially in Europe.

We begin a series of articles on smart order routing by setting out the major challenges presented by fragmentation and the enhanced reporting requirements of MiFID II, and give an example of how itarle ensures that SOR has access to all the information it needs to make optimal routing decisions in the current fragmentation environment.

Demands for Greater Transparency

The Market in Financial Instruments Regulation (MiFIR) and Directive II (MiFID II) require investment firms to publish more details of their use of execution venues and their respective execution quality.

These additional post-trade transparency requirements mean that it is now both a regulatory need and commercial necessity to have access to a best-in-class Smart Order Router (SOR).

Perhaps most important, firms should be prepared to have to justify the decisions made by their routing algorithms, as they will have to report their top five execution venues by volume over the preceding 12 months, as well as many other metrics of execution quality, such as the proportion of passive and aggressive orders.

[Related: “Hands Across the Sea: Best Execution, US vs. EU”] 

Of course, the overarching aim in all this is to prove that all sufficient steps were taken to achieve best execution and that potential conflicts of interest were avoided (for instance, where there is a close relationship between the executing party and the chosen venue).


European markets may well face another explosion in the number of execution venues, with Systematic Internalisers (SIs) coming online in large numbers as brokers seek to continue to interact electronically with clients in a principal capacity. Importantly, this has implications for transparency too.

Updated requirements in best execution and post-trade disclosure have essentially redefined the role of the SOR. If the firm must justify its routing decisions, the SOR must be part of a closely integrated execution strategy.

That issues of fragmentation and transparency are interconnected is a good indicator of how firms should be rising to the challenge ahead of MiFID II’s implementation in January 2018. The best prepared will be thinking in terms of Einstein rather than Newton.

Relativity and Reallocation

Most market participants implement their SORs and benchmark algorithms as totally separate components. Although this is superficially appealing – the SOR is responsible for optimal slicing in “venue space,” the benchmark algorithm in “time” – in the spirit of Einstein’s general relativity we at itarle believe that treating the problem as a space-time continuum is a better approach.

Why? Because – especially with passive orders – it stands to reason that the reallocation logic should be different if the SOR order has been received as a DMA order from a human being, to that when it forms part of a much larger algorithmic execution over the day.

In the case of the DMA order, the SOR must assume that there is no further volume to execute once this order has completed, and so will reallocate across venues as it receives fills to attempt to maximize passive execution.

For the algorithm-generated SOR order, the reallocation strategy across different MTF order books can be different. Rather than moving volume from one order book to another, the benchmark algorithm can allow the original orders to retain their queue priority by releasing more volume that can be placed on different venues.

This is just one of the ways that we make order routing truly smart.

Start Off on a Firm Footing

Only those whose routing capabilities are fully up to date, and have the ability to react to changes in the execution landscape in a timely and agile way, stand a chance of doing well in a world of increasing scrutiny.

It will also pay dividends to keep a close eye on the changing fragmentation trends both pre- and post-MiFID II. As markets become more and more complex, adaptive algorithms – in particular, those that route orders for best execution – are sure to play an ever greater role in helping firms to outperform while remaining compliant.

[Related: “Smart New Rules for Smart Order Routing?”] 

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