Indian stock exchanges have followed up on the Securities and Exchange Board of India’s (Sebi) end-August circular on smart order routing (SOR). They have sent out circulars detailing procedures and rules for members applying for SOR technology. SOR enables best execution in the world of electronic trading, with the trading engine picking up the venue that offers the best price at any given moment.
While the circular of Bombay Stock Exchange (BSE) more or less echoes Sebi’s, the National Stock Exchange’s (NSE) circular released last week has a few additions. For instance, while referring to best execution policy, the Sebi circular included the following factors that need to be considered by a broker member offering SOR: price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.
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The NSE circular attempts to flesh this out, prescribing a best execution policy. It states, “This Best Execution Policy sets forth policy and execution methodology for client execution on the best terms. Upon acceptance of a client order for securities listed on a securities exchange within India and on specific client instruction regarding execution, trading member shall endeavour to execute that order in accordance with the following policy: a) Where the security is listed and/or traded on multiple recognized stock exchanges (multiple listing), the trading member shall determine the recognized stock exchange where to route the order or part of the order based on factors such as price, comparable market data, speed of execution, market depth, liquidity, cost of execution and likelihood of execution and size of the order. b) All SOR orders shall be of the order type Immediate or Cancel (IOC).”
Illustration: Shyamal Banerjee/Mint
Without doubt, BSE would have issues with the new terms and conditions such as the requirement of IOC orders and NSE’s attempt at defining best execution. NSE, on the other hand, would have a clear line of reasoning as to why it’s prudent to have a best execution policy. Before getting any further, it does seem like Sebi’s well-intended circular hasn’t fully resolved the SOR issue between the two exchanges.
Without getting into the merits and demerits of NSE’s best execution policy, it must be said that the meaning of the term best execution can be subjective. Very often, the decision as to where to route a client order is pretty straightforward—for a buy order, it would be the venue providing the lowest offer prices, and for a sell order it would be the venue providing higher bid prices. In such cases, it is easy to detect if a broker performed its fiduciary responsibility of providing best execution for clients.
But there could be times when, say, 90-95% of the order is best filled on one venue, while another venue is offering the next best price for the remaining 5-10% of the order. In such cases, some investors may just prefer to route the entire order to the first venue rather than split the order and go through the inconvenience of settling the trade with two clearing houses. Some other investors may not mind splitting the order to benefit from the better pricing the second venue is offering. Best execution, thus, means different things to different investors.
According to an article in The Trade magazine, “Merrill Lynch’s smart router, SORT, uses a number of techniques to achieve best execution. For example, it stores real-time feedback on individual stocks at each venue, so that orders that are not getting filled can be onward routed instantly to a venue with a better chance of a fill. SORT also enables routing away from exchanges undergoing technical difficulties and ensure higher overall uptime.” Some of the parameters Merrill’s SORT uses in making these decisions may be different from what another broker uses. If that is the case, it wouldn’t make sense for exchanges to be rigid about best execution policy. With best execution, a one-size-fits-all approach wouldn’t work.
When investors deal with human traders at broker desks, it’s based on the trust that they would be providing best execution. Intuitively, one would think that they should also be able to trust these brokers to design SOR technology that keeps their best interests in mind. In that case, this should really be an issue between clients and brokers. Even so, there is the possibility of misuse of a trading engine and Sebi’s policy of requiring a system audit by an independent firm and vetting by exchanges is prudent.
After all, in a world where brokers can receive payment for order flow or rebates, it isn’t necessary that brokers would always act in the interests of clients. But exchanges shouldn’t take this too far and prescribe how exactly best execution looks. As pointed out earlier, in some cases, best execution may look different to different people.
Thankfully, the Sebi circular requires exchanges to communicate its decision on a SOR application within 30 days of receipt. This way, no exchange can inordinately delay SOR approval and one would also soon know if any exchange is using onerous pre-conditions to disallow applications.
NSE’s and BSE’s circulars have come within a month-and-a-half of Sebi’s circular, and prima facie, it does look like both exchanges are working towards making this a reality.
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