The Buy-Side's SOR

Simo Puhakka, Chief Executive Officer, Pohjola Asset Management Execution Services Ltd looks at the development of a Smart Order Router that meets the buy-side’s needs.

In 2011, Pohjola Asset Management Ltd (PAM), Finland’s leading fund manager, launched its Smart Order Routing and Algorithmic Trading Service in partnership with Investment Technology Group Inc. (ITG). The origin of this offering was PAM’s desire to reduce slippage costs when trading equities for their funds. In order to take full control of the routing logic, PAM built its own buy-side controlled SOR (Smart Order Router) with ITG.
What is this Smart Order Router built “by the buy side, for the buy side?” It is something different from that offered by traditional brokers: its’ sole purpose being to provide the right price at the right time.
It quickly became apparent that there is demand for this type of offering from other institutional traders. A separate entity, PAMES, was established to market and further develop the buy-side SOR. PAMES, which is a fully owned subsidiary of PAM, currently offers the SOR to institutional traders and asset managers. Its aim is to work with like-minded buy-side companies and to provide a low cost, highly efficient execution facility that delivers dramatically improved trading performance.
Is PAMES saying that traditional brokers do not always offer superior execution quality for their clients?  The answer is: probably.  In fact, traditional brokers’ routing logic quite understandably includes the need to create value for themselves. This is not the case for the buy-side SOR which does not, for example, internalise orders, look at trading venue fees or maker/taker refunds and is not conflicted by ownership of alternative trading venues.
When sending an order to the broker, the root of the problem is, what happens before the order goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalisation, market making and crossing, not to mention the routing logic? It is noteworthy that whilst many brokers have the ability to connect to multiple venues, our investigation has revealed that a disproportionate percentage of flow is executed in very few venues which might lead to higher opportunity costs for the buy-side.
In our case, the buy-side SOR user group has control over the SOR routing logic and the router is designed to avoid conflicts arising from internalisation of flow, costs of entering certain trading venues, venue ownership and other factors that may affect the quality of the execution. As an example, we would not rest the order in an internal venue nor would post or leave an order sitting in a venue purely for financial gain. Our SOR seeks and finds liquidity from number of different venues.
We believe that the traditional brokerage business model cannot be truly compatible with buy-side´s interests and thus it is likely to limit the quality of execution.
You sometimes hear people arguing that the brokerage market is a very competitive market, and thus those who do not offer best execution would not survive. The brokerage market is very competitive, but it is still not even close to being truly competitive due to the high barriers of entry and number of uninformed customers.
Having said that, we cannot solely blame brokers for the prevailing situation. There is simply not enough demand for high quality execution because of the buy-side´s inability to measure it. If brokers believe that their customers cannot measure execution quality, they are unlikely to provide it, as it is more profitable not to. Any broker who spends resources and increases costs to provide unrecognised execution quality will be undercut by those who do not. All this leads to an acceptable level of execution quality, which, unfortunately, does not equal best execution.
In order to change the present state of the market, the buy-side need to increase their understanding and become better informed – you simply cannot buy something that you cannot see. We all know how to conduct traditional macro level TCA but that is just not enough. Buy-side trading desks would need to dig deeper into the TCA numbers and combine traditional TCA with micro-level analysis. Through the micro-level analysis we are for example, able to monitor the quality of our routing, which has an impact on traditional TCA numbers.
Fortunately, over the past few years we have started to see the buy-side becoming more informed.  More buy-side participants have joined PAMES buy-side SOR user group to work with like-minded companies leveraging each others’ expertise and thus creating value for each other. In addition, at the end of 2013 we saw the launch of a new buy-side owned alternative trading system in the US, where brokers act only as subscribers. The platform shares the same goals as PAMES by promising to provide the opportunity for the buy-side to maximise trading at the best available price without unnecessary intermediation. It seems that buy-side is slowly starting to demand efficient, non-conflicted execution – something that should be self-evident.