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Investors urged to look hard at routing

Fines offer wake-up call for institutions on how trades should move

David Weisberger
IHS Markit’s David Weisberger

Updated with correction

Recent settlements over market makers providing misleading information on equity trades have put institutional investors on notice that they need to take a closer look of how their trades are routed, sources said.

The fines against Citadel Securities along with Deutsche Bank Securities and Credit Suisse over misleading trade execution show that investors and regulators “aren't taking (brokers') word any more” on best execution, said Peter Maragos, CEO of agency brokerage Dash Financial LLC, New York.

“This should be a call to action for both asset owners and institutional investors,” David Weisberger, managing director and head of trading and quantitative services at IHS Markit, New York, said of the Jan. 13 announcement that Citadel Securities would pay $22.5 million to settle Securities and Exchange Commission charges that it misled other brokerages in getting the best market price on retail orders.

IHS Markit is among a growing number of firms — including Trade Informatics LLC, LiquidMetrix and Babelfish Analytics, even market makers like J.P. Morgan Chase & Co. — that are providing trade order routing transparency for institutional clients.

“In the institutional world, there's virtually no scrutiny of routing, so what do you think is actually going on?” said Mr. Weisberger. “In retail, with a halogen light shining down, this still goes on. There's no data on fill rates and other information on the institutional side that provide the basis for market comparison. If you think Citadel is doing it, there are hundreds of institutional brokers with no scrutiny of their routing.”

That lack of scrutiny, sources said, can open the door to trades being routed to exchanges and dark pools based more on rebates and lower fees than on best execution. In Citadel's case, algorithms did not take the other side of the orders, called internalization, at the best price observed — but reported to clients that it did.

Many money managers aren't doing their due diligence on routing, said Rob McGrath, former global head of trading at Schroders PLC, New York. “Some of the bigger guys are on top of this, but only a handful; the majority aren't,” said Mr. McGrath, who left Schroders in July and is now consulting with financial technology developers on trading applications.

Mr. McGrath said the issue with many money managers isn't ignoring transparency but rather knowing what to look for. “It's not popular to say, but it's because they don't know what they don't know,” Mr. McGrath said.

“They (managers) don't know the questions to ask, and the brokers certainly don't make it easy on them. The idea is that if people can just tell you enough to satisfy you, that's what's happening. If you know what to ask for, you'll get it, he said.”


Citadel's actions, and those of other financial service firms that settled with the SEC over misleading trading, are evidence why transparency in equity markets is necessary regardless of whether the clients are institutional or retail, although the trading process for each is much different, said Mr. Maragos of Dash Financial.

“In the Citadel case, they agreed to take the other side of the order,” Mr. Maragos said. “With institutions, there's more capital commitment and proving liquidity. They use trading technology and execution brokers to prevent things like what Citadel did. With transparency, institutions wouldn't let (market makers) trade against other liquidity providers. In that way, it's the same as with retail. With no transparency, the same thing could happen to institutional investors. The mechanics of it would be different, but the best-execution transparency paradigm is the same.”

Data from TABB Group bears that out. In its 2016 Institutional Equity Trading report, 37 of 100 head traders at money managers and other buy-side firms surveyed said they wanted more information on routed flow, order placement and unfilled orders. Also, 35% wanted the SEC to require that trading data definitions be standardized.

“The story here is that transparency is increasing,” Larry Tabb, New York-based founder and research chairman

of TABB Group, said in an email accompanying the data. “Firms are working with their brokers to determine their routing, but they would still like greater transparency in routing and order placement, and the standardization of definitions is important so folks are not talking apples and oranges.”

Mr. Tabb said interviews for the 2017 report are underway, “and in at least my conversations, it seems like firms are getting increasingly more information to the point of not being able to fully analyze it all. Folks don't need more information, they need a better framework for putting it into context and doing something with it.”

Important issue

The issue of transparency for unfilled orders cited in the TABB report is an important one, Markit's Mr. Weisberger said. “Institutions rarely look at unexecuted orders,” Mr. Weisberger said. “That's the problem. The issue here is the allegation of why the broker didn't execute when he should have because it was beneficial to the broker not to. It happened at Citadel. Do you think it could be happening at institutional brokers if no one is looking?”

On seeking SEC requirements for trading transparency, Mr. McGrath, the former Schroders head trader, said he'd prefer to let the market decide, since those managers that can get transparencyand convey it to their asset owner clients in terms of costs and performance impact will get more business than money managers that can't.

“I felt like it's a competitive advantage for a manager to know this,” Mr. McGrath said. “Tell me the rules of the game. To say that the government should mandate this, as a manager you should already know this and use it as a competitive advantage.”

This article originally appeared in the January 23, 2017 print issue as, "Investors urged to look hard at routing".