The topic of this post is order routing, specifically, the routing of algo child orders directly to electronic liquidity provider (ELPs) for execution. This issue has been of considerable interest to buyside traders not only because many buyside traders view ELPs with suspicion in general, but also because the routing arrangements between ELPs and brokers are often opaque.
Clearly, such routing arrangements provide benefits to both brokers and ELPs. Brokers benefit because ELPs provide financial incentives, which could take the form of either payments from ELPs to brokers (i.e., “payment for order flow”) or lower fees relative to those charged by exchanges. ELPs benefit because the financial incentives may result in brokers placing ELPs relatively high in their routing tables. Plus, if the brokers route primarily “benign” flow (e.g., retail flow, “informationless” algo flow, etc.), ELPs may earn larger per-share trading profits than by trading in lit markets.
From the client’s perspective, however, the benefits of these relationships are less clear. Some have argued that the impact on clients is negligible and potentially positive because ELPs provide prices that are at least as good as the exchange quotes, and possibly better (i.e., they may give price improvement relative to the NBBO). Plus, if the order were routed directly to an exchange, it would interact with the same ELPs anyway.
Others, however, believe that these arrangements are detrimental to clients. Specifically, by routing to ELPs before routing to the exchanges, clients could incur opportunity costs, if prices move adversely prior to execution. In addition, and potentially more damaging, routing to ELPs may result in information leakage. For example, if the ELP executes multiple child orders from the same algo parent order, the ELP may view its increasing inventory position as an indicator that a large trader is present in the market. The ELP may respond by trading aggressively to get ahead of the large trader’s impact or, at a minimum, by quoting less aggressively to avoid increasing their inventory further. Both actions could lead to increased costs on future child orders, leading to an overall increase in the parent order’s execution costs.
An empirical question…and some empirical results
Ultimately, then, the net effect of ELP routing on execution costs is an empirical question. And until recently, there had not been a rigorous, independent examination of this question. However, a recent academic study put out by three academics, Professors Robert Battalio, Brian Hatch, and Mehmet Saglam, attempt to answer this question using parent order and fill data from a major U.S. broker’s VWAP algo.
In their paper, the authors perform three separate analyses. First, the authors analyze the correlation between ELP participation and execution costs, holding fixed other factors. Next, they compare the execution costs of clients whose orders were routed to ELPs to the costs of those that forbid ELP routing. And lastly, they compare the execution costs before and after one of the broker’s clients instituted a ban on ELP routing. The conclusions across the three methodologies were consistent.
Specifically, the authors found evidence that, on average, ELP participation increases the cost of trading, both on the child and parent levels. Second, the authors found that clients whose orders were restricted from being routed to ELPs had lower costs than those whose orders were routed to ELPs. And third, for the single client who initially allowed its orders to be routed to ELPs, their execution costs declined following their decision to restrict such routing. In each case, the authors conclude that higher ELP trading leads to increased execution costs in their sample.
Of course, the analysis above shows the aggregate effect of ELP routing for a specific broker’s VWAP algo. So it is possible that the results may not hold across all brokers or all algos. And while the client-level analysis showed that turning off ELP routing improved trading performance, the reduction could be unique to that specific client. But regardless, the evidence indicates that ELP routing can have a negative impact on performance. And, perhaps more importantly, the broader implication of this study is that routing decisions can have a significant, measurable impact on aggregate, parent-level execution costs.
The key takeaway then is that buyside firms could benefit significantly by assessing how routing decision influence their aggregate execution costs. The first step in the process is simply understanding how brokers route their orders. Fortunately, the SEC recently approved enhanced broker disclosure requirements to give clients more transparency on how their orders are routed. But such data only provides the starting point for firms wishing to enhance their execution quality. To determine the best routing strategy, buyside firms need to analyze the question for themselves – either with internal resources or external consultants like The Bacidore Group (the obligatory shameless plug) – using their own data.
And it should be noted that the data the authors use in their study are the exact same data available to any buyside firm that routes orders via FIX. Buyside firms simply needs to ask their brokers to pass back the executing venue on execution records. And that is often just an email or phone call away.
One last thing…
Before concluding, we would like to thank those people who have provided comments on earlier posts. We really appreciate the feedback. If anyone has comments on any of our posts, suggestions for future topics, or would like more information on The Bacidore Group, please contact us using the form at the bottom of the page or email us at email@example.com.
The author is the Founder and President of The Bacidore Group, LLC. The Bacidore Group provides research and consulting services to buyside and sellside clients, including assistance with broker algo customizations, "algo wheel" design and analysis, custom TCA frameworks, custom algo development, and bespoke quantitative analysis.
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 In their paper, the authors refer to ELPs as High Frequency Liquidity Providers, or HFLPs.
 The sample only contained one client that instituted a ban in the middle of the sample.