Best execution is under enhanced scrutiny by regulators who are lining up potential conflicts of interest in their crosshairs. Regulators are bringing actions against brokers in relation to contentious trade routing issues. Regulators allege that some broker-supplied algorithms have prioritised particular trading venues, or shared order information with certain market participants. Whether this was intended or inadvertent, it might not have been visible to customers.
Regulators also allege that some brokers have not provided clients with the most comprehensive, accurate and transparent description of how, where and why order routers transmit orders and trades.
These concerns around the growing complexity of execution are in fact nothing new to seasoned options and equity market traders. The co-founders of disruptive fintech firm Dash Financial have deep backgrounds in algorithmic equity and options trading. CMO David Karat worked at Investment Technology Group (ITG) for 10 years from the nascent phase of algorithmic trading before moving to Credit Suisse. CEO Peter Maragos began his career as an equity options market maker and risk manager for Tahoe Trading LLC, firstly on the floor of the Chicago Board Options Exchange (CBOE), and then on the floor of the American Stock Exchange (AMEX). The two entrepreneurs have a knack for spotting growth niches. Prior to co-founding Dash, Maragos served as the Chief Executive Officer of LiquidityPort, a fully electronic brokerage platform for all NYMEX ClearPort products including Blocks, EFPs, EFSs, and options before running SDS Financial Technologies Inc., where he designed, built and operated various over-the-counter alternative trading systems in the US Treasury repo, European government bonds (EGB), EGB repo, CD/money markets, mortgages and ADR to ORD segments, as well as the Futures and Options Exchange Platform for the Chicago Climate Futures Exchange.
The genesis of execution technology firm Dash lay in three inter-related execution trends. Firstly, execution technology was continually advancing, leaving behind some participants who were not up to speed with the necessary hardware and cutting-edge software techniques.
Secondly, market microstructure was becoming more complicated, the number of US options exchanges, for example was up to 14, soon to be 15, from only six when Karat and Maragos started in the business. There was growing divergence between exchanges, order types, pricing models and matching algorithms as well as continued fluctuations in pricing schedules and business models. “Suddenly you could not just set up a router – you needed to be an expert in routing technology and market microstructure,” recalls Karat.
Thirdly, routing itself was changing as “sub-optimal or incentive-based routing resulted in institutional orders being filled without supplying performance from the client’s perspective,” Karat explains. Moreover, the options market was in Maragos’ opinion rather opaque: “We found ourselves in an environment where it was simply impossible to understand where a broker was routing orders on behalf of their clients and it would take literally weeks to ascertain the total cost of an execution. We felt we could solve this problem”.
Around 2009 the two conceived a disruptiveplan: they would build best-in-breed, highly customizable technology and deliver complete real-time transparency to show people where they were routing and executing orders and break down all the costs associated with each and every fill, utilizing financial technology to act as a pure agency broker dealer. Customisation was seen as a way to keep customers sticky, and it has worked well. Having launched in Q2 2011 executing US equities and options, Dash already executes more than 6% of the US options volume and has grown to over 40 employees with offices in New York, Chicago, and San Francisco.
Dash is a FINRA broker-dealer and covers US equities and listed equity options and is a member of all options and equities exchanges, the OCC (Options Clearing Corporation) and the NSCC (National Securities Clearing Corporation). As well as providing a full suite of equity routers and algorithms, Dash customized their technology to cater to the US options microstructure as “this was a much more advanced problem to solve than equities from the beginning,” Maragos, who had made markets on the CBOE, recalls.
The quirks of the options world include different pricing structures for different ‘capacities’ (customers, professional customers, broker dealers, firms, etc.). Some exchanges pay for liquidity provision and charge for taking liquidity while others are ‘inverted’. Yet “these building blocks of a trade cost were not easily deciphered and without the transparency into child-level execution, people could not determine the net cost of a trade. Aside from that was the fact that much of the industry simply paid an ‘all-in’ price to their brokers,” Karat remembers. Dash operates in a ‘pure agency’ capacity and offers clients a ‘cost-plus’ pricing model, charging clients a transparent commission for execution and passing through rebates and fees. An ‘all-in’ pricing model is one price which effectively includes the broker commission and an assumption of the fees, whereby in turn, the broker assumes all exchange rebates and costs associated with the execution.
Exchange rebates are among multiple venue specificities factored into Dash’s routers, which are iterated every time there is a fee change issued by an exchange. Dash hones and refines algorithms regularly, utilizing quantitative analysis to work out performance and slippage. “As pricing models fluctuate and the behaviour of the market place changes, we need to tweak our methodology to continually capture best execution from the client’s perspective,” Maragos explains.
While Dash has ultra-low latency infrastructure, they are not targeting the ultra-low latency trading community but utilize speed and timing to ensure they do not have a disadvantage versus other market participants.
In this fast changing arena, smart routing is essential and Karat states: “We are a technology firm that happens to be a broker dealer and not the reverse”. He explains: “It is almost impossible for the institutional community to keep up with the nuance of the microstructure in such a way that will allow them to optimize execution…that is where we come in. A large part of our process is education, and we spend a lot of time consulting with our clients to tailor our products to fit their exacting liquidity capture and cost optimization profiles – having an architecture that can be configured in real time without re-coding is clearly essential to this.”
Transparency is a key component in the order routing process to help understand, audit and customize the order routing process and Dash has been a force for openness from the start. “We launched in 2011 with unique transparency people had been crying out for,” says Karat. Dash prides itself on maximum transparency for traders, decision makers and compliance officers, who are provided with a login to see every element of an order, every decision made and why they were made, in a very granular breakdown providing pre-trade and post-trade transparency as it is happening.
Dash delivers the full lifecycle of a trade, from its inception as an order, through its journey as child-orders to the various market venues and all the way to clearing. The web-based Dash 360 dashboard lets clients see every order routed to each and every destination and the accompanying execution includes a full picture of all the ingredients that feed into pricing: commissions, liquidity flags, maker taker fees, rebates, and other exchange levies including exchange-specific transaction fees, trade processing fees, royalty fees (for singly-listed options products such as the VIX and the SPX).
Dash displays in real time how an order is being executed including a complete wave-by-wave breakdown displaying what was available on the order book at each corresponding strategy step, the size of the order the router sent and the subsequent fill, breaking down the fill percentage and even the transport and matching engine latencies. Dash’s proprietary Trade Cost Calculation Engine (TCCE) disseminates the fees and levies which may be categorized by category, time-range, group, trader, symbol, and algorithm. An animated Order Visualizer adds some eye candy to the offering.
“Some firms cannot offer this level of transparency and some do not want to while neither execution management systems nor order management systems are able to”, according to Karat. “Because we are agnostic to the EMS/OMS/FIX methodology our clients wish to use, we are able to provide DASH360 to all our clients via web delivery, and HTML5 allows us to display this in a customizable dashboard accessible via PC, tablet and PDA. The visualizer allows us to effectively show a video of what we see in our minds when we audit an order to prevent the client from having to try and assemble grids of numbers to create a picture on their own.”
Customisation and consultancy
Dash offers a wide suite of algorithms but these are not an auto-pilot solution. How algorithms are used and combined is critical, and Dash makes its expertise in execution, venues and microstructure available to clients. Explains Karat: “Algorithms alone are no longer a source of competitive advantage as everyone can create horizon algorithms such as TWAP. Now it is more about tactical choices at the routing layer.”
Karat goes on: “Using our proprietary ‘Algo Wizard’ we can configure algorithms and routers down to the most intimate detail and customize a multitude of behaviours such as how the product will behave pre-open, how it will randomize, how long the product waits for the order-book to refresh, how much volume has to appear before it reacts, which venues to hit in different scenarios…the list goes on.”
Dash coins the phrase ‘bespoke innovation’ which speaks to how its routers and algorithms are tailored to client needs. Dash’s technology team have designed and delivered customised architecture that can dynamically adapt as market microstructure changes, removing the need to code and lengthy release cycles for each new exchange, changes in venue rules or routing methodology. “We change the dials for routers and a new pricing structure gets automatically incorporated,” states Karat.
Dash allows clients the ability to optimise thesensitive balance between liquidity capture and fees. An event driven strategy might need to obtain liquidity swiftly for example, while a strategy with an expected holding period of several years could be more patient about getting a better fee profile. “The key is to work with the client to ascertain their liquidity and cost profile to understand how the router or algorithm should work, and then adjust the fee sensitivity of the router to that client,” Karat says. The customisable architecture allows clients to balance this trade-off at the order, strategy, PM or firm level. “For every method you use to increase cost optimisation, the trade-off is often invariably a degradation in liquidity capture percentage,” explains Karat. Dash can calibrate the tolerances for each client, set different parameters for particular traders and even for individual instruments. Maragos explains that “having Dash360 allows our client to view the behaviour of our products as it is happening. This may prompt them to communicate with us and inform us that in scenario ‘x’ I want to behave ‘y’ – we can adjust the product specifically for them and even for a specific symbol, in real time, have them resend an order and witness the new behaviour…that is very powerful.”
Dash provides a variety of algorithms that can be geared towards achieving a range of best execution benchmarks and they offer their expertise and experience to clients who require consultancy advice. Below we outline at high level some principles underlying the algorithms; traders can go into far more depth and detail in terms of the features that can be tweaked and customised.
Dash’s flagship SENSOR, Smoke and Blitz routers are available for both equities and options and they allow clients the ability to determine the trade-off between capturing liquidity, and optimising costs / fees, and varying the balance between displayed and non-displayed liquidity. Smoke is an example of a ‘no post’ routing tool that allows the user to define when it ‘pounces’ and as with all their products, the exchanges included in the routing table for specific behaviours allow users to specify a preference for rebate only exchanges, free exchanges, debit exchanges or a combination.
Algorithms for trading options
Dash has five routers and algorithms for options. As well as SENSOR, Smoke and Blitz that are also available for equities, Dash has some options-specific products. Blitz routes listed option trades to a configurable set of exchanges with microsecond precision to maximise liquidity capture across multiple venues. In contrast the VOLT algorithm is based more on option pricing in implied volatility terms. VOLT is also designed for volatility arbitrage trading and has an auto-hedging feature that allows the option to hedge stock automatically, maintaining delta neutrality, often utilized for gamma trading strategies.
Maragos finds clients in options markets are most concerned about sourcing liquidity and says “if the order is a similar size or greater than the NBBO volume, our niche is to achieve that volume before the bid/offer moves away from the order, a result that requires finesse and technique”. Dash also provides a Time Weighted Average Price algorithm (TWAP) which seeks to obtain better prices while executing at a steady pace throughout a defined time range. “To minimise market footprint, it has developed an ‘anti-gaming’ feature that uses binomial randomisation to stop the market from seeing orders coming, by randomising time and quantity,” adds Karat. All of these algorithms also have many more subtle and nuanced features that may be customised.
Algorithms for trading equities
Dash has 13 routers and algorithms for equities and each one creates a child order based on a specific benchmark; the child order is then routed through Dash’s SENSOR routing layer to optimize for liquidity and fees. “VWAP became popular on the equity side because there had to be a common way to measure brokers, as huge institutions with 300 brokers had to easily benchmark them and VWAP was an easily defined metric,” recalls Karat. But whether VWAP is appropriate depends on the fund’s strategy.
Volume Participation lets users specify what percentage of volumes they want to trade over a time window; Flexible Participation adjusts the rate based on price moves, and Synthetic Peg is designed to maximise liquidity rebates, while Rapid allows for real time adjustment of participation rates to try and capture more liquidity.
Implementation Shortfall in contrast benchmarks execution prices versus the arrival price and Dash’s Close Algorithm aims to minimise price impact and slippage against the close as a benchmark estimating the optimal time to start participating in market and the order percentage to utilize in the closing auction, leaving some flexibility over when to start the non-auction part of the order.
The Dark algorithm integrates access to multiple types of venues: dark pools, crossing networks, streaming liquidity venues and open market destinations. Like other Dash algorithms it is pre-programmed with venue-specific rules, such as crossing times and minimum size. In contrast Phantom switches between lit and dark venues to optimise execution objectives.
Dash has integrated with approximately 30 different front-end systems, including EMS/OMS systems such as EZE Castle, Bloomberg, Charles River, Realtick, InfoReach, SS&C, Neovest, Flextrade, Mixit, Obsidian, Redi etc. as well as direct FIX-in integrations from proprietary systems and strategies. Currently DASH trades only listed equities and options but the partners regularly review their business strategy for opportunities in the future. “MIFID II will encourage geographic and product expansion, as it makes a verifiable audit trail of execution and price discovery a hard requirement,” says Karat.
Though MIFID II formally applies in Europe, Karat thinks its spirit will change mind sets elsewhere because “in Europe or Asia or the US or wherever, people need to verify and evidence an audit trail to demonstrate price discovery and best execution, regardless of regulations. Even if the regulatory winds do not take us there the business winds will do so”.
Though Dash has a full suite of equity products, Karat admits “it is harder to break into the equity space as there is more competition – and people pay for research using equity flow”. MIFID II’s greater separation of commission and research should move best of breed execution closer into focus, and a number of asset management firms have already announced in early 2016 that they will split the two, ahead of MIFID II’s delayed implementation in 2018.