In S3’s view, Best Execution is not merely a regulatory requirement, a single number or a compliance driven checkbox. Instead, it is the process of monitoring, improving and managing the quality of the primary product for many financial services companies – a security transaction. In a world where advanced supply chain management has made it possible to track the exact time and location a specific widget was assembled, as well as who was managing the shift, which supplier’s bolts were used that day and what the standard deviation of the failure rate is, large swaths of financial services companies are still using the same processes they were employing a decade ago. Instead of taking advantage of current tools that allow for instantaneous analysis of every single transaction, they rely on summaries of subsets of their transactions with the results being delivered weekly or even monthly. Companies that still employ these practices are at significant risk for becoming uncompetitive due to insufficient best execution monitoring.

Their inability to compete is not due to failing regulatory exams or paying too many fines, for just as the federal government has minimum safety requirements for all automobiles, building a car that can pass them does not make a successful car company. Instead, the danger is in losing customers to competitors that are better performing and more well prepared as exhibited by the following scenarios.

How We Engage

Retail Brokers
Problem

Retail Broker XYZ is in full compliance with BestEx regulatory requirements. Every month the Best Execution committee dutifully reviews the execution performance statistics for their 605 eligible covered orders. Through careful selection of routing destinations and firm oversight, XYZ consistently has EFQ numbers that are better than the industry average and is proud to publish them on their website. In addition, they periodically review all 605 eligible covered orders for egregious exceptions and attempt to get corrections on behalf of their client.

The flaw in this type of monitoring process is that many client orders fall outside the monitoring net. A client who places a stop loss order, clients who trade options or pink sheets or bulletin boards, all these scenarios can see a client receive a substandard quality product via a poor execution; not only does this not impact the most commonly measured best execution statistics but it may not be reviewed at all. If these individual orders are being reviewed, it is often with a significant time delay sufficient to prevent corrections being obtained from market centers – especially in the case of options. In today’s competitive broker environment, it is unfathomable that so many participants would risk losing client accounts and tarnishing their brand’s reputation for quality executions by simply not adequately monitoring such a large percentage of the product it delivers to clients every day.

S3 Solution

S3’s industry leading Best Execution platform allows broker dealers to comprehensively monitor for quality across every single US equity and option order placed by their clients with results returned intraday. This combination of complete coverage and rapid results transforms the broker from being reactive by dealing with poor executions that are either historical or initiated via a customer complaint to being proactive by getting adjustments for their customers before their customer even realized there was a problem. In an increasingly commoditized landscape, the value of customer service differentiation continues to increase.

Options Exchanges
Problem

An option exchange is frequently on the NBBO, offers a competitive payment for order flow model and has reasonable fees yet continues to yield market share to its competitors. The team responsible for monitoring BestEx for the exchange reports nothing unusual, executions occurring at NBBO, average speed in line, etc, via their internal toolset that provides overall summaries of all executions. What the team does not see though, is that a small percentage of orders, all tagged with a specific time in force, are taking approximately 10x the average to execute. Unfortunately for the exchange, this order type is popular among high volume option traders and instead of having this kind of a delay wreak havoc with their high speed algorithms, they have elected to drop the exchange all together from their smart router’s exchange table.

S3 Solution

S3’s Best Execution platform allows an exchange to see each and every order from the view of their customer. Robust price and speed analysis are performed on every order and the web interface automatically alerts the users of any outliers. The ability to view the resulting analysis of all this data on a daily basis ensures that any potential deviations from expected performance are immediately found and corrected by the exchange prior to client impact.

Routing Destinations
Problem

A routing destination is losing flow to its competitors. Upon further inquiries with its customers, it learns that the competitors have agreements with their customers that guarantee a certain percent of orders will be price improved. In addition, these competitors are providing the customers detailed reports showing price improvement on an individual order level. The competitors are also able to use this detailed information to manage their internal executions as they can reduce their margins when they’re below the target price improvement percentage, and increase them when they’re above.

S3 Solution

S3’s robust Best Execution platform provides functionality for a routing destination to measure any specific execution statistic for each individual order as well as at an aggregate level. S3’s sub-portal technology allows the destination to expose directly to their clients the details of their order flow that was routed to the destination. The reports and statistics that are seen by the client are customized to prominently feature the statistics that differentiate the destination (speed, execution quality, liquidity, etc). By using S3, clients not only get access to all this additional information but they have an increased level of comfort with the validity and integrity of the reports since they were generated by an industry respected third party.

Toxic Order Flow

Order routing destination has a flat all-in fee structure with multiple clients that are routing significant daily volumes. Their business model is built on the premise that the average cost to execute the trades is less than the all-in fee structure. Unbeknownst to them, one of their clients has deployed a new High Frequency Trading system that has an order to fill ratio of over 500:1; this high rate of fills to cancels has triggered cancel fees at some of the exchanges where they route business. These fees are now more than offsetting their profit margin and they are losing money daily. However, since the firm is dependent on receiving bills directly from the exchanges it will be at least 30+ days before it receives an invoice showing the high level of incurred cancellation fees. Furthermore, the exchange invoice will likely only show the total charges for orders it routed, thus not making it obvious which of their different clients was responsible for the increase in the order to fill ratio.

Solution

S3's automated billing system allows clients to see the actual revenue generated and fees incurred on an individual client basis on a same day or T+1 basis. This allows the order routing destination to review its profitability daily and make necessary adjustments to fee structures or client relationships in order to negate the impacts of "toxic" order flow. A robust rule-based engine supports all fee structures currently in use at all US equity and option exchanges as well as custom fee arrangements between routing destination and client.

For further information contact James C. Moore at jmoore@s3.com