Smart order routing (SOR) is an automated process of handling orders, aimed at taking the best available opportunity throughout a range of different trading venues.
The increasing number of various trading venues and MTFs leads to a surge in liquidity fragmentation, when the same stock is traded on several different venues, so the price and the amount of stock can vary between them. SOR serves to tackle liquidity fragmentation, or even benefit from it. Smart Order Routing is performed by Smart Order Routers - systems designed to analyze the state of venues and to place orders the best available way, relying on the defined rules, configurations and algorithms.
History of Smart Order Routing
1980s
The forebears of today's smart order routers appeared in the late 1980s: "In an attempt to lock in the client order flow and free traders up from smaller trades, in order to handle the larger trades, many of the larger broker dealers began to offer a new service called or DOT. DOT boxes were the first electronic machines to provide the institutional buy-side with what we now call "direct sponsored access", they, however, were not very smart yet (they could be directed to only one destination, the New York Stock Exchange)".
By 1988, SuperDOT included "roughly 700 communications lines that carry buy and sell orders."
1990s
It was in the US, in the late 1990s, that the first instances of Smart Order Routers appeared: "Once alternative trading systems (ATSes) started to pop up in U.S. cash equities markets … with the introduction of the U.S. Securities and Exchange Commission’s (SEC’s) Regulation ATS and changes to its order handling rules, smart order routing (SOR) has been a fact of life for global agency broker Investment Technology Group (ITG)."
2000s
As a reaction to the introduction of MiFID (Europe) and Reg NMS (USA), Smart Order Routers proliferated in Europe in 2007–2008, their sole purpose consisting in capturing liquidity on lit venues, or doing an aggressive or a passive split, depending on the market data. Later the SOR systems were enhanced to cope with High Frequency Trading, to decrease latency and implement smarter algorithms, as well as work with dark pools liquidity.
Here are some US statistics from 2006-2007: "Smart order routing capabilities for options are anonymous and easy to use, and optimizes execution quality with each transaction". "In a study conducted earlier this year in conjunction with Financial Insights, BAS found that about 5% of all equity orders were executed using trading algorithms, with this number expected to increase to 20% by 2007".
Smart order routing may be formulated in terms of an optimization problem which achieves a tradeoff between speed and cost of execution.
Benefits and disadvantages of Smart Order Routing
SOR provides the following benefits: Simultaneous access to several venues; Automatic search for the best Price; A good framework for usage of custom algorithms; Opportunity to get additional validation, control and statistics;
There are, however, some disadvantages: Additional latency; Additional complexity, and, therefore, additional risk of loss/outage; Transparency of information, concerning your transactions, for the third party;
A brief concept
The idea of Smart Order Routing is to scan the markets and find the best place to execute a customer's order, based on price and liquidity.
Thus, SOR can involve a few stages:
1. Receiving incoming orders through different channels: An incoming FIX gateway; An incoming Gateway based on any custom protocol; A front-End; 2. Processing the orders inside the SOR system, taking into account: Characteristics of available venues; Custom algorithms; Settings/preferences of a certain client; The state of available markets/market data; Venue parameters, such as average latency, commission, and rank can be used to prioritize certain venues. Custom algorithms, like synthetic orders (peg, iceberg, spraying, TWAP), can be used to manage orders automatically, for instance, if a specific client has certain routing preferences among several brokers, or certain rules for handling of incoming, or creation of outgoing orders. It is also crucial to track the actual venue situation, like the trading phase, as well as the available opportunities. Thus, any Smart Order Router requires real-time market data from different venues. The market data can be obtained either by connecting directly to the venue's feed handlers, or by using market data providers.