Order Routing

Order routing is the step in the trading process at which an order to buy or sell a financial instrument is directed to a place where it can be executed. When the same share, bond or derivative can be traded on several exchanges, on alternative trading venues and directly with dealers, a broker must decide which destination, or which combination, will give the best result for the client. In electronic markets the decision is made by software in fractions of a second.

Routing became a significant function once regulation and technology ended the dominance of single national exchanges. In the United States a share may trade on more than a dozen exchanges and several dozen off-exchange venues; in Europe on its primary exchange, competing platforms and dealers' own books. Routing is the practical means by which brokers meet their duty of best execution, and it is one of the main subjects of market microstructure.

An investor's order first arrives at a broker, usually through an order management system. The broker may handle it in several ways. It can send it straight to a venue specified by the client, known as directed routing. It can pass it to a market maker or wholesaler that executes it against its own account. It can cross it internally against another client's order. Or it can hand it to an execution algorithm, which decides how to split the order over time, and a smart order router, which decides where each piece goes.

The two tools address different questions. The algorithm manages the trade-off between speed and market impact for the parent order. The router takes each child order and, at that instant, selects venues.

A smart order router maintains a consolidated view of prices across the venues to which the broker is connected, built from each venue's market data feed. For an order that is to execute immediately, it identifies where the best prices are displayed, splits the order among those venues in proportion to the quantity available, and sends the parts simultaneously so that quotes on one venue are not withdrawn in reaction to a trade on another. For an order that will rest in the market, it chooses where to post, taking account of queue length and the probability of execution, and it may move the order as conditions change.

Routers also probe venues that do not display orders, such as dark pools, for a chance of execution at the midpoint of the bid-ask spread before or alongside sending to lit markets.

Brokers weigh a number of considerations, and their relative importance depends on the client and the order:

• Price and size. The best displayed bid or offer and the quantity available at it, measured by order book depth.
• Explicit costs. Venue fees, rebates paid to orders that add liquidity, and clearing and settlement charges.
• Likelihood and speed of execution. Historical fill rates, the venue's latency and the risk that a quote disappears before the order arrives.
• Information leakage. The risk that other participants detect the order and trade ahead of it, which is higher on some venues than others.
• Price improvement. The chance of trading inside the quoted spread, for instance with a systematic internaliser or a wholesaler.

Rules differ between the main jurisdictions. In the United States, Regulation NMS, adopted by the Securities and Exchange Commission in 2005, includes an order protection rule that generally prevents a venue from executing an order at a price worse than the best protected quote displayed elsewhere. In effect this makes price the overriding criterion for immediately executable orders and obliges venues to route away or reject orders they cannot fill at the best price. Brokers must publish reports on where they route customer orders.

In the European Union and the United Kingdom, MiFID II imposes no equivalent trade-through rule. Instead, each firm must take all sufficient steps to obtain the best possible result for clients, considering price, costs, speed, likelihood of execution and settlement, size and nature of the order. Firms must set out their approach in a best execution policy, obtain client consent to it, monitor its effectiveness and be able to demonstrate compliance. For retail clients the test is total consideration, meaning price together with costs.

A broker's own economics can pull against the client's interest. Venue rebates may tempt a broker to post orders where it earns the highest rebate rather than where they are most likely to trade. Routing to an affiliated venue or internal pool saves fees for the broker. Payment for order flow, in which a wholesaler pays the broker for retail orders, is the most debated example and has been restricted or banned in several jurisdictions. Regulators address these conflicts through disclosure, policies on inducements and supervisory reviews of routing decisions, and institutional clients increasingly audit their brokers' routing with their own transaction cost analysis.

The same function exists outside equities. In foreign exchange, aggregators route orders among bank and non-bank liquidity providers. In crypto-asset markets, routing software splits orders across centralised exchanges and decentralised pools. Venue outages and extreme volatility test routing systems, which is why firms subject them to algorithmic trading controls.