FOW Learning: Smart order routing systems - What they are

It’s risen in popularity in recent years as market fragmentation has increased, and it’s often used to trade large orders, slicing them across multiple venues, optimising price, time and speed, and managing risk.

In this article, we’ll look at the smart order routing meaning as well as its benefits, drawbacks, and the role it can play in derivatives trading more specifically.

What is smart order routing?

Smart order routing (SOR) is the use of technology by financial institutions and traders that monitors all the trading venues it’s connected to, meaning that it automatically directs clients’ orders to the best available one. It scans the venues for the best available opposite order taking into account factors including price, speed, and liquidity.

The smart order router uses a reference venue to compare all orders on the alternative venues. It’s the main venue where the product is being traded, so it will typically be a well-known exchange like the New York Stock Exchange, London Stock Exchange, or Euronext Amsterdam.

With so many different trading venues, the bid and ask prices can vary. So, the smart order router ensures that the order is screened across the activity on all the venues to give clients the best execution price, while improving efficiency and reducing costs at the same time.

How does it work?

SOR strives to give clients the best execution price quickly and efficiently, but there are some complex technologies behind it, with numerous routing rules that help match orders.

For order routing applications to fulfil their obligations, they focus on active bids, requesting quotations with matching liquidity levels across major exchanges and dark pools – private securities exchanges in which investors, often large institutions, can make trades anonymously. Because they’re prone to market fluctuations and display distinct liquidity levels, the SOR system will prioritise the most profitable execution point, considering cost and liquidity.

First, a trader submits an order. When it reaches the system, it will analyse the different variables, like pricing, liquidity, and market volatility, and then route the order to the most appropriate venue. It may slice it into smaller orders and route them to different exchanges or pools, ensuring the best price and minimising the impact on the market.

Types of smart order routing

There are several types of smart order routing system, each one designed to meet slightly different needs. The most common types of SOR are as follows:

• Cost-based SOR: This prioritises venues based on cost, taking into account any transaction fees. The aim is to carry out the order at the lowest possible cost, so it monitors the fees of each venue and will opt for the one with the lowest.

• Time-based SOR: Whereas cost-based SOR prioritises cost, time-based SOR prioritises them based on the speed of execution to take advantage of the best price on the market before the situation changes.

• Liquidity-based SOR: Liquidity-based SOR prioritises venues per their available liquidity, executing the order with as little impact on the market as possible and reducing the chance of slippage.

• Volume-weighted average price SOR: Also known as VWAP, this smart order routing system prioritises venues based on their volume-weighted average price. VWAP is calculated when you divide the total value of the trades by the total volume traded during a given time. Generally, this SOR is used for large orders, and the aim is to execute them at prices as close to VWAP as possible.

• Dark pool SOR: This type of SOR prioritises venues that are dark pools. By routing the order to dark pools, it aims to minimise both the impact on the market and the risk of more opportunistic traders taking advantage of predictable market moves.

Another option sometimes used by traders is to divide smart order routing into basic, advanced and algorithmic types, as follows:

• Basic SOR: The simplest type, a basic smart order routing system will focus on a single factor like price or speed on small, simple orders. However, it’s not as flexible and might mean that it doesn’t lead to the best overall outcome.

• Advanced SOR: This will usually incorporate multiple factors and is often used with medium-sized orders and multi-venue trading. It’s also more adept at adapting to changing conditions in the market.

• Algorithmic SOR: This is more complex, and can include types of SOR including VWAP, and tends to be better suited to larger orders and high-frequency trading.

Capabilities of smart order routing

Smart order routing has a few capabilities, varying slightly depending on the type. These are among the most common:

• Order slicing: This is a way to execute orders – particularly larger orders – with less market impact. Smart order routing can break an order down into several smaller orders and distribute them across multiple venues, trading them over time until the order is filled.

• Adaptive routing: Smart order routing can adapt to sudden changes in market conditions – for example, if there’s a large trade on a decentralised exchange. Parts of the order can be rerouted to different venues in real time, helping to ensure the best performance.

• Price, time and speed optimisation: Because SOR systems consider factors like price, time, speed and liquidity, they’re able to better determine the best places of execution.

• Risk tolerance and compliance: When using smart order routing, it won’t exceed the level of risk the trader is willing to take. And SOR systems are designed to adhere to regulatory standards to ensure transparency.

Benefits and challenges

There are both benefits and challenges to smart order routing, though some will be more applicable to certain situations than others. These are some of the primary benefits of SOR:

• Price optimisation: Because SOR systems analyse data across multiple markets and venues, they help traders ensure that orders are executed at the lowest cost to buy or the highest price to sell.

• Reduces market impact: Smart order routing slices large orders into smaller ones, spreading them across different venues to minimise the impact on the market and reduce the likelihood of significant movements in price.

• Greater efficiency: SOR reduces the need for manual searching, saving human time and energy. Not only does this improve efficiency, but it can reduce the likelihood of errors and delays at the same time.

• Offers access to various liquidity pools: SOR systems can connect traders to multiple liquidity pools – not just exchanges, but dark pools and other trading systems too – to help you select the best venues.

• Can support complex or specific goals and requirements: Traders can customise the configurations to meet particular trading objectives, while those with more complex strategies can use SOR to optimise trading across multiple legs.

Meanwhile, these are some of the most common challenges and potential drawbacks of smart order routing:

• It can be difficult to understand: For traders who aren’t as experienced, smart order routing can be harder to understand and configure, meaning that they may not find the best results at first. Not all exchanges and brokers support SOR, either, meaning that even when traders have a considerable degree of understanding, it may not be as effective as it could be.

• Can be affected by market instability: You can expect SOR systems to work best in stable market environments. However, when the market is more volatile, they may not be as efficient. Manual oversight is important so that any unexpected activity can be interrupted.

• Best price execution is not guaranteed: SOR systems consider several factors – like market volatility, liquidity and market data – but there’s no guarantee that orders will be completed at the best price.

• Chance of technological issues: If there’s a technical issue or failure, this may make SOR systems less efficient or accurate. It’s also worth considering that SOR needs a powerful IT infrastructure in place, and its implementation can be expensive.

SOR in derivatives

Smart order routing can have a big part to play in derivatives trading. Derivatives markets are often split across multiple exchanges, while trading manually can be time-consuming and prone to slippage, so smart order routing can help traders become more time and money efficient.

Sometimes, contracts for the same underlying asset a derivative is based on can be listed on more than one venue with different pricing and liquidity, but SOR systems can allow traders to buy and sell contracts on more than one venue to secure arbitrage opportunities. They can also help those trading across multiple legs to optimise efficiency and ensure that traders trying to mitigate risk can execute orders without affecting any underlying positions.

So, if a trader was looking to buy and sell contracts across multiple venues at the same time as part of a multi-leg strategy, an SOR system would ensure that each leg is executed at the best price, minimising slippage.

SORs can help traders and companies comply with regulations, too, by providing transparency and audit trails.

The performance of a smart order routing system will be dependent on the accuracy of the reference data, and that’s where FOW Reference Data comes in. We provide everything you need to enable smarter decisions in derivatives markets with standardised detailed data sets and our Symbology service to support operation accuracy and market connectivity across the front, middle and back office.

To find out more, take a look at our data solutions. We can help you put smart order routing into action and apply it to your trading.

Frequently asked questions

• How does smart order routing work?
  It works by analysing market data across major exchanges to direct orders to the best available venue, meaning that smart order routing considers factors like price, speed, and liquidity to achieve the best execution price in real-time.

• Why is smart order routing important in derivatives trading? Smart order routing is important in derivatives trading, and this is because derivatives tend to be fragmented across numerous venues with varying liquidity. By using SOR, firms can ensure efficient trading at the best prices and optimal liquidity.

• Can smart order routing reduce trading costs? In short, yes. It does so by monitoring multiple venues to find the best prices and reduce slippage and slicing orders across them to reduce market impact. It also reduces the opportunity for human error and can make the process more efficient.

• When should smart order routing be used? It’s best to use smart order routing when a firm needs to find the best execution for a trade across multiple venues, optimising factors including price, liquidity and speed, particularly when trading in fragmented markets.