Some exchanges have made a strategic shift in deciding to route orders to dark pools and multilateral trading facilities.

The emergence of new alternative trading venues and smart order routing is posing a challenge for traditional exchanges. To compete effectively, they need to think strategically. Sell-side firms already have the tools to handle smart order routing. Buy-side firms are slightly behind the curve, but they want to acquire this capability. Exchanges can play a role by becoming smart venues, thereby benefiting from an open playing field and access to multiple markets. 

According to Steve Leegood, Founding Director of UK-based technology consultancy Bryok, as smart venues, exchanges could impose differential tariffs, which could change according to the time of day or level of liquidity in a particular asset class. “This would make exchanges more competitive on a very dynamic basis,” he says. “It is the same principle that airlines use in occupancy-based cost of flights, which changes moment by moment as flights reach maximum occupancy.”

Smart order routing originated in the US equity markets as a means to cope with the fragmentation of liquidity experienced during the growth in electronic communications networks (ECNs). With smart order routing, trades are automatically routed to a predetermined list of execution venues.

In Europe, smart order routing is less well established. But the condition that led to its uptake in the US – liquidity fragmentation – is emerging as a number of new trading venues appear following the implementation of the European Commission’s Markets in Financial Instruments Directive (MiFID).

Simon Nathanson, President and Chief Executive of Neonet, a Stockholm-based provider of global direct market access brokerage services and trading technology, says Europe is at the beginning of a wave of fragmentation. “Neonet has always thought that we will see new venues such as multilateral trading facilities (MTFs) and dark pools,” he says. “Very early on, we realized that market participants would need help to find the best liquidity, not only when they hit the other side in an aggressive trade but also when they are not aggressively placing an order.”

“Neonet has built a second generation order routing system that adds more intelligence,” says Nathanson. “This system looks not only at where the best price is, but also at the best probability of transacting a trade.”

Hedge funds and proprietary trading desks are continuously seeking new markets in which to apply their arbitrage and statistical algorithms. Currently, hedge funds in the US and Europe are fine tuning their algorithms to work under different circumstances in several markets in Asia-Pacific, including The Singapore Exchange (SGX) and the Australian Securities
Exchange (ASX).

Asia-Pacific has lagged the US and Europe because the liquidity pools in the region are scattered and competition between exchanges is less intense. While the Asia-Pacific exchanges are eager to attract algorithmic traders, the challenge lies in understanding their requirements and in anticipating the level and extent of their participation.

Routing to dark pools will become an important factor for exchanges, according to Brian Hyndman, Senior Vice President, Transaction Services at NASDAQ OMX. “In the US, the real change in smart order routing this year is that we are now connecting to a variety of dark pools. Earlier this year non-displayed pools of liquidity accounted for 6 percent of the overall market; by September it was closer to 8 percent, and it continues to grow,” he says.

In Europe, it is early days, says Hyndman, but NASDAQ OMX is in discussions to route to dark pools. “Our clients want us to check out dark pools before their orders are routed to the public market. For major market centers and exchanges to be competitive, they will have to connect to dark pools and accept client demands.”
 

By HEATHER MCKENZIE

MarketView 2008:2