Financial Regulatory Forum

ANALYSIS-Inefficient systems keep European brokers behind the price curve

December 18, 2009

By Jane Baird

LONDON, Dec 18 (Reuters) – Europe’s fragmenting stock markets could cost investors profits unless brokers smarten up systems that currently fail to find the best price in 15-20 percent of trades.

Brokers use so-called smart order routing (SOR) to compare prices across the myriad platforms for a client’s order, chop the order into pieces and dribble them into trading venues to have the least possible impact on price.

Systems in Europe are often inefficient and are struggling to keep up with the pace at which markets are changing.

“All the brokers talk of their smart order routing capabilities, but in a lot of cases the use of the word ‘smart’ is actually wrong. They are incredibly clunky,” said Tony Whalley, head of dealing and derivatives at Scottish Widows Investment Partnership.

The equity market in Britain is divided between 25 exchanges, trading platforms and dark pools, Germany is split between 22 and France 23, since the European Commission’s markets in financial instruments directive (MiFID) opened up competition in 2007.

“A big part of smart order routing technology is about reconstituting the market so that it glues back together the bids and offers from all the different venues that have emerged,” said Steve Grob, head of group strategy at Fidessa.

U.S. regulation makes exchanges and trading platforms responsible for routing an order to another venue if it has a better price. Prices there are defined by a consolidated tape — a single reporting system for prices from all public venues.

In contrast, Europe has no consolidated tape, while regulators discuss the possible merits of creating one. Its routing systems also need to take into account the varied options and costs for clearing and settling a trade.

“In Europe, we don’t yet have any concept of a mandated best European bid and offer,” Grob said. “All the emphasis is on the brokers to smart route.”

European SOR systems overall are far from doing the job they should in making sure pricing is efficient, said Richard Balarkas, chief executive officer at Instinet Europe Ltd.

 

MISPRICINGS

The solution will ultimately depend on investors’ ability to evaluate broker performance.

Trade execution is becoming a “front and centre” priority for buyside clients and a criterion to exclude brokers, said Ian Peacock, global head of execution services at CA Cheuvreux, Credit Agricole’s European broker.

The big banks, which have been distracted by the credit crisis, need to refocus on upgrading technology, and some smaller players will have to realise that their survival could hinge on investing to get the systems right.

“The speed of change is accelerating because of new entrants, new markets and new types of liquidity,” said Peacock.

“It’s not just a one-time investment but the start of a process of continual investment that’s going to become more complex,” he said.

Balarkas said that the big banks were not necessarily motivated to design top-notch systems, because filling client orders in-house was more profitable, with commissions from both sides of a trade, no fees to exchanges and a first crack at an order by their own proprietary traders.

Frederic Ponzo, a managing partner at consultants GreySpark Partners, pointed to other problems: “Some of the banks’ SOR systems are clunky because of sedimentation of old software built up over the years, while development of others is held back by in-fighting between fiefdoms within the bank.”

Equiduct data for September shows that aound 14 percent of orders on the London Stock Exchange and Chi-X, 18 percent on Euronext  and 22 percent on Xetra missed a better price on another public order book.

When reviewing trades in major European stocks in a single day, Nov. 20, Instinet found thousands of instances — 7,822 for Siemens  alone — in which a seller in one venue wants a lower price than the buyer is willing to pay in another.

Balarkas said this never happens in the United States.

It tends to occur in Europe when the U.S. market opens up and orders flood in and after U.S. job figures and other market-moving data, said Ponzo.

SOR is increasingly key to competition between brokers.

“In the United States, they don’t ever talk about smart order routing. It’s like saying, ‘We’ve got a telephone,’” Balarkas said. “Here smart order routers are central to brokers’ trading capabilities.”

After MiFID, banks imported systems developed for the U.S. market and adjusted them to European rules and conditions, Ponzo said. “The first attempt was to take an American SUV to ride the roads in the City of London.”

Now there is a tendency to overcomplicate the systems being purpose-built for Europe, he said.

“Everybody wants Porsches and Ferraris, but they are not necessarily the best for driving the potholes of the Square Mile,” he said. “In the end, smart order routing is about getting the basics right.”

(Editing by Sitaraman Shankar)

((jane.baird@thomsonreuters.com, Reuters Messaging: jane.baird.reuters.com@reuters.net, +44 207542 2471))

 

Friday, 18 December 2009 10:36:36RTRS [nLDE5BF0ID] {C}ENDS

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