Liquidity Right Under Our Noses: The Benefits of Smart Posting
Not Smart Enough?
Known as smart routing, the use of technology to reduce manual intervention while maximizing sourcing capabilities at unimaginable speeds became an industry standard by the late 1990s. Smart routers, through instruction by a trader or algorithm, take direct market access (DMA) to a new level. A smart router acts as a sweep tool to probe the spreads and find hidden liquidity, accessing multiple exchanges and ATSs one by one, all in an effort to satisfy best execution and increase performance intelligently with as little footprint as possible.
When a smart router has exhausted its sources, it will end up executing whatever instructions remain. Usually, those instructions are to camp on an ECN and post an order that shows only a small quantity along with a hidden reserve in the event that a larger order comes in. If stock trades on another ECN, the smart router generally will cancel the order where it currently resides and migrate the balance of the instructed order to where the volume is, both missing the stock that traded on the bid and paying higher prices to catch up to the instructed participation of volume.
The hesitation by institutions to open up due to the potential for information leakage has erected a roadblock between buyer and seller. We are all worried about gamers, front-runners and shoppers, hence the need for anonymity. Technology has opened us up a bit, however. There are scientific and mathematical parameters set in these electronic routers and algorithms. Therefore, we have developed a certain level of trust in them.
The problem here is that the National Best Bid and Offer (NBBO) usually is crowded by numerous buyers and sellers. Your algorithm might camp your order on Arca waiting for a seller to hit your bid, but BRUT, which might also be offering the best bid, may get hit instead. After your algorithm sees BRUT being hit, it will migrate your order to that marketplace in an attempt to participate in the volume. If it is too late getting there and you have any sort of a volume participation instruction, your algo likely would take offers in an attempt to maintain a percentage of the volume.
While the algo certainly has served a number of functions, it has failed in several respects. It may be too late and you may have missed not only the volume traded that was advertised, but also any hidden reserve. In order to catch up, you may have to chase the stock higher in order to participate. This is a double whammy as you are now not only lifting offers at higher prices, but also paying the spread.
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