Smart Order Routing

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21 Aug, 2024

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Smart Order Routing (SOR) Meaning

Smart Order Routing (SOR) is a facility or technique within the trading platform where traders can scan and identify the best possible buy or sell price for a security and place an order according to it. The advanced algorithms provide this opportunity to take advantage of the price differences in different exchanges.

Due to innumerable trading venues or platforms for investing, there is liquidity fragmentation. Therefore, it is necessary to have a system that will show the best price available to trade automatically. It has gained popularity very fast, especially among institutional investors who trade in huge volumes and want to minimize the risk of the same.

Smart Order Routing (SOR) Meaning

Smart Order Routing (SOR) is an automated system in any trading platform that searches for the best possible price for placing an order related to buying or selling.
This facilitates traders, especially the ones who trade in large volumes, to control risk.
The advanced algorithm uses factors like transaction fee, market condition, type of order, and speed of execution during the process.
It helps optimize the trading process automatically and straightforwardly, due to which it has gained immense popularity in the financial market.

Smart Order Routing Explained

Smart Order Routing (SOR) refers to an automated system included in the trading process of different platforms, where there are algorithms designed to search for the best available price for a security in the market to trade. It is applied for both buy and sell orders. It is a highly efficient and time-saving technique that is suitable especially for institutional traders who place orders in large volumes.

The need for this smart order routing system arises from the fact that a security is traded across different markets and trading venues or platforms. Therefore, there is always a price difference between them. To get the best deal, it is essential to have an automated system that will show the lowest price available during the buy order and the highest price available during the sell order. It cannot be done manually since, in that case, there will be enough room for mistakes, and it will be extremely time-consuming and complex.

Due to the many trading venues available in the financial market to place orders, there may be price differences that create liquidity fragmentation, which is efficiently handled through the SOR. Many stocks are traded in multiple exchanges. If a system like SOR is not in place, then the trader may not have updated information about the best price available and, as a result, lose the opportunity to make a profitable trade.

There are various techniques available for the same in the market. It is primarily used in online orders, but during offline orders, too, it can be used where the trader speaks to the broker to make suggestions about the best price of a stock to place the trade.

Types

It is essential to understand the various types of smart order routing systems available in financial markets. Each type has its method of executing the trade depending on the objective of trading. Let us study them in detail.

Time-based SOR – As the name suggests, this method is highly dependent on time. It gives the most importance to the execution speed so that it is possible to take maximum advantage of the opportunity of the market. In this case, speed is essential because the reduction in execution time will help identify the best price, and delay will cause the price to change.
Liquidity-based SOR – In this type, the order execution is based on liquidity, which is the priority over here. Through the algorithm, that order is selected and executed, which impacts the market in a minimum way and has the highest liquidity. In this way, the slippage risk is reduced, and the order gets executed at the best available price.
Cost-based SOR – This method of smart order routing algorithms is the most important to the execution cost. This cost includes all transaction fees that the brokers or exchanges process during the order execution. The algorithm executes the order at a cost that is lowest among all through proper analysis of all the fees of all venues and selecting the venue that has the lowest fee.
Dark-pool SOR – It also gives priority to those order executions that are dark pools. These trading venues are anonymous because they do not publicly show the orders before execution. Such algorithms will aim to execute orders with minimum impact on the market by routing orders through dark pools. This stops or controls the activity of those traders who can take the opportunity of a predictable market to get a good trade.
Volume-weighted average price SOR – VWAP is the route that gives priority to an order with a considerable volume, and the price is calculated based on the formula of VWAP, which is the total value of the trade by the total volume. In this case, such orders are selected whose price is the closest to the VWAP.

It should be noted that each of the above types has its advantages and disadvantages. Therefore, it is necessary to understand what kind of trade is helpful and what kind of trade can be analyzed based on objective and type of trading.

Configurations

This section focuses on how the process works on different trading platforms. After a trader places an order, the system will scan for the best liquidity levels and prices that are available in the market across all exchanges where the particular stock of security is traded. Therefore, there is no manual effort involved in smart order routing technology. They can be either a buy or a sell order and an intraday or delivery trade, too. Any standard or limit orders can also be used, where the former is executed at any particular market price that is best available at that time, and the latter is executed at the price mentioned explicitly by the trader.

Thus, one can summarise it using a few stages, like getting orders from different channels by using an incoming gateway through Financial Communication eXchange (FIX), processing the order by considering the features of the venues, the algorithms, the preferences of traders, and the market condition and data. Then, the orders are routed through any one venue after considering the various features of the order mentioned above.

However, even though the process of smart order routing algorithms looks simple, during practical execution, there are many complexities. The main complication is during intraday trading. In case the entire lot is not available at the best price in one exchange, it needs to be split into multiple parts to be executed in different exchanges at the best available prices. Sometimes, the entire order is not executed. Thus, a trader should keep track of their order through the order book and trading book.

Brokers typically use or permit usage of this concept in case of large orders only when there is enough liquidity.

Examples

Let us study the concept of smart order routing technology with the help of some suitable examples, as given below.

Example #1

Let us take the hypothetical example of an Immediate Or Cancel (IOC) Order. In this kind of order, the execution should take place immediately. It can also be partially fulfilled if the entire order is not available for fulfillment. But then the rest is canceled. Suppose the order is to buy a stock where the volume is 1000, and the price is $22.5. So, the SOR selects three available best prices from three different venues:

a. Volume – 200, price $22.5

b. Volume – 300, price $22.5

c. Volume – 300, price $22.6

So, the order gets executed as per the above volume and price in three venues. However, 800 volumes were executed, and 200 are left, which are canceled. Next, the order history should be viewed by referring to the order book and the trade book. These records will help in understanding how many orders were executed in which exchange.

Example #2

The financial markets around the world are now experiencing an Artificial Intelligence (AI) based SOR, which is different from the others because of its separate bid and ask liquidity tiering tool. Overbond Ltd has created this tool, which is very valuable and helpful in achieving end-to-end automated bond trading. Market participants believe that it will make an excellent contribution to the trading of fixed-income securities.

It is typically quite challenging to determine the liquidity of the bond market by the traders before trading. Both buy and sell side traders have to face this challenge. Thus, with this AI-driven tool, the algorithm can change or adapt as per the volume and direction of trade.

Pros And Cons

Now, let us understand the pros and cons of the concept of smart order routing strategies in detail.

Pros:

Best price – This system helps analyze data collected from many markets because a stock may be traded in multiple venues or exchanges, which causes price differences to arise.
Access liquidity pools – It successfully traders to many liquidity pools of stock exchanges, dark pools, or Alternative Trading Systems (ATS).
Reduce impact on the market – The system can successfully prevent any considerable impact on the market due to significant price fluctuation. It achieves this by breaking large orders into small parts and routing them through various venues.
Customizable – The system can be changed and customized as per the objective or trading.
No manual searching – It is an entirely automatic process where the system searches for the best prices using specific algorithms.

Cons:

Complex system – Traders who are not quite experienced or educated may find the system complex and difficult to understand. In such cases, they will not be able to use the process in an optimal manner that will benefit them.
Technical issues – Since it is entirely dependent on the software and technology, there is always a possibility of technical issues and software not working on time or any other kind of failure. This will significantly affect the trading process and may lead to huge losses, which cannot be recovered.
Effect of market volatility – This system works well if the market is considerably stable and normal. In case of any unusual condition or fluctuation, proper results are not given. It will have a negative impact on the efficiency of the process, rendering it not so helpful.
No guarantee of best price – Since the system makes decisions based on many different matters like market conditions, which include volatility and liquidity, transaction fees, and other types of market information, there is no guarantee that the best price will be picked up by the system for execution of an order.

Thus, the above are some of the most essential benefits and drawbacks of smart order routing strategies. While using it, traders should note and understand the above.

Smart Order Routing vs Algorithmic Trading

The above are two different techniques that are used for trading in the financial market. But there are some critical differences between them as follows:

Even though both are automated in nature, the former is used to execute trades that will select the best possible price from multiple markets. However, the latter used mathematical models during trading.
The former can be described as a process that directs orders toward the best execution. It analyzes various venues based on different attributes. However, the latter does not involve the above.
The former divides a big order into smaller parts to direct them to the required destination, while the latter deals with the main order itself directly.
Due to the above, the former successfully reduces the impact of large orders in the financial market and prevents price fluctuations, but the latter may result in volatility.

Frequently Asked Questions (FAQs)

How to close Smart Order Routing orders for intraday trades?

The concept and its execution become complicated in the case of intraday trading. The orders are completed totally on the basis of liquidity available in the market. In case of insufficient funds, however, the complete SOR order remain unexecuted.

When did the Smart Order Routing first appear in the market?

It first appeared in the market in the late 1980s. Dealers started offering a new type of service called Direct Order Turnaround (DOT) to handle large trades efficiently. This was modified to Super DOT later on. However, the real SOR appeared in the US during the late 1990s. It spread into Europe in 2007-08, with the primary purpose of capturing liquidity, depending on market information.

What are the general restrictions on Smart Order Routing?

Among general restrictions, the brokers usually restrict the type of order. They primarily allow market orders and put restrictions on limit orders. They also put restrictions on very liquid stocks if they are traded in large volumes so that the best price is available. Moreover, it is applicable only in a live market and not in off-market orders because it mainly aims at order optimization during trading hours.