E-trading good but not necessarily best execution

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James Wood-Collins, London-based CEO of Record Currency Management, says the expansion of the FX market, which hit average daily volumes of $5.3 trillion in 2013, is a boost to alpha-seeking funds. However, as dealer participation has stagnated, it has also created challenges.

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"We have seen bank market share remain stable at around 39%, while other financial institutions such as asset managers have increased their market share," he says. "However, profit-seeking financial institutions continue to represent a minority, which suggests that there is still a good opportunity for those with alpha-type skills."

Increased liquidity has led to spread compression in major currency pairs to around 1 basis point, compared with 2 basis points five years ago. One of the reasons for that is the proliferation of e-trading platforms, which have been presented as a solution to issues of compliance and transparency.

"E-trading is particularly useful for spot transactions, accounting for around 64% of transactions," says Wood-Collins. "In forwards, swaps and options e-trading it is used in about 45% to 52% of trades, and overall our e-trading volume is about 40% of our business, compared to 10% in late 2012."

The e-trading universe can be broadly divided into three categories: single-dealer platforms, electronic communication networks (ECNs) and multi-dealer platforms.

"Single-dealer platforms, which are run on a request-for-quote basis, do not inspire confidence in terms of achieving best execution, but they can offer a quick comparison tool for other prices offered," Wood-Collins says. "ECNs meanwhile offer streaming pricing from multiple sources, and are most useful for spot markets. But for hedging we use forwards and banks are understandably less willing to offer streaming prices on forwards because of the credit risk involved."

Multi-dealer platforms offer and compare both spot and forward prices from multiple banks, and usually operate on a request for quote basis.

"A multi-dealer platform is the most comprehensive option, and almost 40% of our transaction volume is executed on this basis, a little bit below the average for non-bank financial institutions. The percentage is not subject to a hard and fast rule but is the outcome of our trading team seeking the best execution venue for each and every trade, and the proportion tends to vary over time."

The introduction of swaps functionality on e-trading platforms over the past two years was the direct cause of Record’s increased use of the platforms, Wood-Collins says.

Still, he says e-trading is not the be all and end all and there are plenty of scenarios in which alternatives are a better bet, and when Record went through a period of growth in its passive hedging business it turned to the swaps space.

"As passive hedging grew, we relied more on FX swaps, with two linked transactions closing out a spot transaction and opening up a forward. It’s critical that you link those transactions so that effectively the spot price embedded in the forward contract, the far leg, is exactly the same as the spot price at which you are doing the near leg, because we don’t want to be paying a spot spread. So there are two linked transactions and up until quite recently the platform we were using could not accommodate that."

There are additional reasons why e-trading would not be the optimal solution, Wood-Collins says.

"The best price for large transactions will often be found by dealing on the phone. Also many of our clients expect us to manage their credit risk actively and therefore we often need to tailor the allocation of transactions to fit their parameters, and you can only get a limited amount of banks to quote at the same time on an RFQ platform, which is a constraint. 

"Perhaps most importantly, currency market conditions vary from day to day and therefore it is essential if you want the best possible price to maintain both e-trading and phone dealing infrastructure."