In a simple world, when an investor places a trade order, whether online or over the phone, the order goes to a broker. The broker then looks at the size and availability of the market to decide which path is the best way for it to be executed.
A broker can attempt to fill an order in a number of ways:
Order to the Floor - For assets trading on exchanges the broker can direct the order to the floor of the exchange, or to a regional exchange. In some instances regional exchanges will pay a fee for the privilege to execute a broker's order, known as payment for order flow
Internalization - Internalization occurs when the broker decides to fill the order from the inventory of financial assets the brokerage firm owns. This type of execution is usually accompanied by the broker's firm making additional money on the spread.
Order to Third Market Maker - For assets trading on an exchange the brokerage can direct the order to what is called a third market maker. A third market maker is likely to receive the order if they provide the broker with an incentive to direct the order to them or the broker is not a member firm of the exchange in which the order would otherwise be directed.
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Electronic Communications Network - ECNs automatically match buy and sell orders. These systems are used particularly for limit orders because the ECN can match by price very quickly.
Order to Market Maker - For over-the-counter the broker can direct the trade to the market maker in charge of the stock the customer wishes to purchase or sell. Some brokers make additional money by sending orders to certain market makers.
Once the appropriate order routing path has been identified, the broker needs to bring the request to the appropriate market in order to find a party wishing to assume the opposite position. Once both parties are found, the second portion of the transaction occurs. This portion is commonly referred to as clearing. While all brokers maintain their own books recording the entire amount of buy and sell orders transacted by clients, the actual act of clearing all these transactions is handled by a clearing institution.
Major Challenges and Trends
Modern-day order management systems are evolving into sophisticated systems that provide automated order management, portfolio modeling, reporting, and compliance features tightly knit together to create a complete investment management solution. There are several new trends in the market that are driving the changes in Order Management Systems. They are growing regulatory and competitive pressure on financial services firms to automate the process; increasing trade volumes, which are stretching the capacity of non-automated processes; and the need to control trade processing costs and to minimize operational risk. In this section, we will explore some such trends and challenges facing OMSs.
Latency is becoming such a differentiator and competitive advantage in a lot of markets, that firms are looking very hard for any means to make them a little faster than their competitors. Successful trade execution demands price discovery in milliseconds-while the data still reflects the actual market. The time interval between when a trade order is sent and when that same order is acknowledged and acted upon by the receiving party is getting shorter and shorter. This includes both:
- Trade-Order Flow Latency
- Market-Data Latency
There is a growing realization that faster internal networks and a state-of-the art client-side messaging transport have the biggest impact on reducing latency.
Best Execution is one of the most critical challenges in trade order management. It involves a lot of steps including prioritization of factors, analysis and selection of execution venues, linkage to execution venues, creation of “best execution” policy, execution of orders, periodic review of factors and venues. Best execution is increasingly becoming a compliance requirement. The challenge here is that best execution policies and order routing algorithms vary vastly from firm to firm, often best execution policies are unstructured content that guide business decisions to be made. Firms are now struggling to formalize these policies and incorporate the rules into OMSs. Also, in their bid to achieve best execution, firms will need to carefully monitor data latency in addition to price and ask themselves whether they should upgrade their systems to cope with the heightened pressure for speed.
TCA is an emerging trend that involves comparison of a firms trading history to the universe of executed trades and thereby assigning execution quality metrics to brokers.
The need of the hour is for a credible framework for effective analysis. An effective TCA framework should include comprehensive Pre (cost queries, algorithmic recommendations, risk bid analysis)- and Post (end of day, longer-term reports, consulting)-Trade analysis by Industry, Country, Past performance and Risk Characteristics. The Post Trade reports need to provide detailed analytics that shall help determine the trade's impact, measure the overall performance of the transaction and analyze the execution quality.
MiFID ( Europe): MiFID has provisions for many areas including conflict of interest, conduct of business, best execution, equity markets transparency, record keeping, client reporting and outsourcing.
Reg NMS (US): Reg NMS has provisions for many areas including Order protection, market data amendments, non discriminatory access to quotations etc.
As these compliance regimes near implementation, most financial services firms find themselves scrambling to comply with the regulations' requirements. Most firms have been working to boost their order-routing capabilities and infrastructure to comply with the regulations and many are fine-tuning their surveillance approach. However, a lot still needs to be done in this area.
In the advent of increasing trade orders & enriched market data connectivity, intermediation of broker groups increases turnaround time for the institutional clients. Buy-side institutions, under regulatory pressure seek best execution and greater control over their trading strategies. In this scenario, Direct Market Access (DMA) proves advantageous as the buy-side can seek ‘best execution’ in terms of greater efficiency and transparency in the trade execution process. With DMA, the buy-side institutions can rent a broker's infrastructure and clear via the broker and at the same time take control of the order flow. FIX messaging standards ensure standardized communication across various counterparties. The real motivation for aggressive DMA trading on the buy side is reduced commissions and trading fees. Through real direct market access investors eliminate any potential conflict of interest with delayed orders or proprietary trading activities.
With increasing volume of trade orders, it becomes difficult to seek the best ‘price’ and ‘allocation’ strategies. Algorithmic Trading allows investors to obtain the best possible price without significantly affecting the stock's price and increasing the purchase costs. These algorithms determine the optimal time for placing an order that will cause the least amount of impact on a price of individual stock or portfolio. Algorithmic trading enables dynamic monitoring of performance until execution is complete.
Establishing reliable external interfaces to critical systems like ECNs, market data feeds, clearing houses etc. have been a major challenge for some time now. Minimizing message delays is another critical challenge that trading firms are facing.
It is no longer a profitable practice for brokers and trading firms to operate in product silos, it is not just hedge funds but traditional investment managers that need to be able to trade across all the different asset classes. Initially, firms have been bringing together their exchange traded equities and derivatives on a single order management system, but this is now going further to include some over-the-counter instruments, as well as the overlay of foreign exchange transactions.
Ensuring the performance of the OMS across all asset classes including equities, derivatives, fixed income, commodities etc is becoming more and more important.
Of late, OMSs are evolving into sophisticated solutions that provide automated order management, portfolio modeling, compliance, and reporting features tightly knit together to create a complete investment management solution. Hence, there is a rush to broaden the functionality of the OMS by including features like Portfolio Management, Portfolio Rebalancing and post trade support.
Order Management Systems, given their mission critical nature and ever expanding functionality, pose real challenges to financial institutions. These challenges are aimed at bringing down the vertical silos of technology that traditionally supported each asset class as well as to ensure regulatory compliance. The emergence of algorithmic trading and DMA provide impetus for organized automated trading. The financial institutions must consider various parameters like Order Routing, Performance Management, Transaction Analysis, Event Monitoring & Exception Management, Scheduling and Third Party Affiliation for selection of OMS solution vendors.
