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| Results index | ||
| Buy side excited by multiple choice | HSBC raises its game | |
| Banks take fight to the algo traders | Methodology | |
“IT’S LIKE HAVING internet sex,” a veteran FX trader tells Euromoney, mangling his metaphors over beer and burgers one April evening, searching for a layman’s explanation for the complexities of high-frequency traders’ behaviour in his market. But perhaps he has made his point well. Because today’s foreign exchange market has become a forum populated by participants who hold multiple identities or aliases to conceal their true selves, where accepted market behaviour is no longer adhered to, attention spans are skittish, and the moment things get a little dicey those participants disappear into the ether. The electronic execution revolution, and the development of more and more sophisticated trading algorithms in recent years, has now created a perverse situation: trading volumes continue to grow, a greater choice of trading venues is available, bid-offer spreads have narrowed to the thinnest of margins, and yet liquidity in the FX market has become more brittle, less transparent, and less customer-friendly. Many in the market attribute that to the behaviour of high-frequency traders, who have invested heavily in the latest telecommunication technologies to game the market, rather than serve its wider interests. This has allowed them to pick off the banks on external exchanges when they look to clear market risk that they can’t match off on their internal platforms.
The leading FX banks argue that these activities undermine the integrity of the market. Now they’re taking a stand; enough is enough. They’re taking on the high-frequency traders at their own game.
“It’s true that the high-frequency community raised the bar on the banks in pricing and risk management and Deutsche Bank is responding by investing in our infrastructure to a point where we will compete on at least a level playing field,” says Zar Amrolia, global head of foreign exchange at Deutsche Bank, which has secured first position in Euromoney’s FX survey for a seventh straight year. “You have to factor latency into your risk management. We resolved that and now we’re putting that in place.”
Amrolia says the high-frequency traders only compete in specific areas but the competition is sufficiently important to warrant the investment. One such area has been the traditional inter-dealer brokers, EBS and Reuters. In particular, bankers say that EBS has become like walking in a minefield for dealers. Its decision, in 2004, to allow large buy-side customers to trade on the platform (before it was sold to Icap) has come back to haunt it. In recent years banks have become better at measuring their trade metrics and figuring out where the losing trades were coming from, and thus identifying where their execution was slipping, and EBS has been a sorry tale. Traders say that historically execution costs of clearing FX risk on exchanges such as EBS were roughly flat. They neither won nor lost. That’s no longer the case. Dealers say that they are probably losing a quarter of a basis point in spread, because the high-frequency traders are faster. Indeed it has proved fertile ground for the algo traders, who now make up four of EBS’s top-10 clients, several dealers tell Euromoney. EBS says there are four in the top 15.
While many say they don’t want high-frequency traders excluded from exchanges such as EBS, they argue that the system needs to be made more difficult to game. For instance, dealers say there are certain HFT funds that have 48 separate identifiers – in other words, 48 separate connections to EBS, making them more difficult to identify. Some banks might have only two. The identifiers, known as EBS AIs, aren’t cheap either. Clients will pay $3,000 a month, before brokerage fees. For a high-frequency guy it’s an easy equation. Spend the money and as long as you make more than you spend, the business proposition continues to pay. For the banks, such a model is harder to justify.
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“If you’re a small weaker player, you are not going to be able to face off with some of these clients given their technology. We would not be in that position” |
“If you look at the profitability on external exchanges over the past three years it’s got steadily worse and where is the money going? It’s going to high-frequency firms,” says Chris Purves, global head of e-trading at UBS. “They’re not cheating, they’re not breaking any rules; they’ve just chosen to concentrate on one particular segment. But the banks have to get rid of risk, and when we try to do so, we find a lot of time these guys on the other side and it hurts us.”
Data released late last year in the Bank for International Settlements’ eighth Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity shows the extent of the proliferation of high-frequency traders. As a whole, market activity increased 20% to $4 trillion a day in the preceding three years. However 85% of that growth came from the increased trading activity of “other financial institutions” – a broad group that encompasses smaller banks, mutual funds, pension funds, hedge funds and others. The BIS concluded that most of that 85% had come from HFT funds. Indeed it claimed that around 25% of all spot FX activity, as much as $375 billion a day, was from that trading type, although it couldn’t verify that figure.
It underlined a more telling statistic: for the first time activity by other financial institutions has now surpassed transactions between reporting dealers. So where did all these HFTs come from?
Many are offshoots of the more mature equity high-frequency funds but many others have spun out of banks’ own high-frequency algo teams in recent years, as they saw the opportunity to arbitrage bank technology. Funds such as Getco, GSA Capital, Jump, Tower and Lucid Markets crop up frequently in conversation with the main dealers, as active participants. Euromoney received little or no response when it called to request interviews with some of these firms.
Dedicated networks
Efforts to nullify the impact of the high-frequency traders are now taking place on two levels. Individually the banks, though not all of them, are seeking more and more to co-locate their servers with HFTs at key data sites, such as EBS’s data centre in Slough, just outside London, and with the CME in Chicago to name just two. Once they’ve done that, banks then attempt network optimization, whereby they have dedicated trading networks instead of a commingling of a bank’s communication networks. Once they have a dedicated trading network, banks can work on enhancing network speeds. How do they do that? Well, the next generation in algo programming means that they no longer need to program using Java or C, because they can now program straight onto the micro chip, allowing for even quicker speeds.
But that doesn’t get you all the way, say technology consultants. A bank could place its server a few feet away from a HFT server, and its signal might still not arrive at the same time. High-frequency firms will go to the lengths of cooling the copper wires, giving them a fraction of a micro-second advantage. It’s now all about micro-seconds, not milliseconds.
On a collective front, the industry has recently explored the idea of creating its own dark pool of liquidity. In March, news leaked to the press that banks were working on a project called PureFX, an all-bank trading platform. This, at face value, appeared to be an attempt to exclude HFT activity. However, a person close to the project tells Euromoney that much of the press coverage was inaccurate. It wasn’t about HFTs but more about raising the quality of infrastructure, and the behaviour permitted on electronic platforms, such as consistency of pricing and minimum quote times.
A protocol on how those rules might be applied became a sticking point, and the reason why the project has been placed on hold, the informant says. “I’m absolutely convinced PureFX will come back in another version,’’ says a global FX head. “Ultimately the banks feel there is a need for such a facility. We need to have a protected environment. It’s the mutual interest of real clients. EBS is not a fair rational clean system anymore.”
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“It is a matter of the manual guys learning to use these tools properly and then they will begin to see algos more positively” |
EBS is attempting to respond by adding additional restrictions on algo traders when they consistently jump 1/10th of a point in front of traders directly trading on the EBS system, typically referred to as the “manual guy”. These types of traders also have another tool to support trading with algos called “pip discretion”, available to manual bank traders, which allows them to enter an improvement to their price. This isn’t available to the algo traders. “It is a matter of the manual guys learning to use these tools properly and then they will begin to see algos more positively,” says David Rutter, the chief executive of EBS.
Some of the main dealers play down the impact of algo traders. Barclays Capital, which has risen one place to second in this year’s Euromoney FX survey, but dropped one spot to third in e-trading market share, says it is not concerned. “We don’t see it as an issue at all,” says Mike Bagguley, global head of FX trading at Barclays Capital. “We feel we’ve achieved critical mass in a number of areas including technology, and we’re comfortable in serving our entire client base, and I’m definitive in saying that,” he says emphatically. “However, if you’re a small weaker player, you are not going to be able to face off with some of these clients given their technology. We would not be in that position.’’
Risk internalization
That’s a strong statement to make, but others articulate the point about adaptive technology, and the ability to move across a multitude of liquidity pools. “The key is to avoid touching them as much as possible, so keep liquidity away from the high-frequency guys. How do I do that? By keeping as much of the business away from the platforms they trade on,” says the chief operating officer for interest rates, credit and currencies at a US bank. “The best way to minimize it is to internalize risk. That’s no different than it was always, it’s just that it’s a little more granular these days.”
It is often argued that the participation of high-frequency funds adds liquidity to the market. This very much depends on who you are. In early April, at a conference held by Profit & Loss in London, a straw poll was held at the end of one session where the question was asked: Do HFT funds add liquidity or reduce it? Delegates were unanimous in their opinion that they enhanced liquidity. It’s often deceptive. For instance, HFTs often come into the market and place a price inside the existing bid-offer prices, which theoretically means they’re improving liquidity, but often it will only be in a small amount of €1 million, which is of little use when the other side of the trade is looking to deal in €10 million.
The move to decimalization of prices, quoted in 1/10ths, on EBS earlier this year is a case in point. UBS conducted an analysis as to whether moving to this added liquidity to the market. Its findings were mixed. On the one hand, it increased the concentration of orders closest to the prevailing market price, otherwise known as order stacking, but widened the gap between the next level of sizable market interest. In effect liquidity was the same, just differently distributed. Indeed there is often confusion between adding liquidity and tightening the price. Dealers say the size of liquidity has changed over recent years. “Seven years ago you could see a yard aside (€1 billion of liquidity on the bid and €1 billion on the offer), and we’re nothing like that, so to say liquidity is increasing is probably wrong. Tighter shouldn’t be confused with liquidity,” says UBS’s Purves.
Often the criticism is that the algos trade in small size, and that when liquidity is required they’re no longer to be seen. “Market making for us is when a market is distressed, when a client comes to us and wants a price in €500 million,” says the head of spot trading at a UK bank. “You won’t get that from an HFT. A market maker in €1 million is totally different.”
With the banks now making noises that the technology arbitrage might be about to close, some say they are noticing a change in behaviour in the high-frequency funds, and a desire to become legitimate market makers. “The reason that change is happening is because I think they see the writing on the wall. I think they see that these exchanges will adapt and that simply being fastest is not enough anymore,” says Purves. “Any forward-looking firm that is looking ahead a year or two has to be planning for a world where simply being 15 nanoseconds faster than the next guy isn’t enough to make you profitable.” Deutsche’s Amrolia concurs: “Do I see a world where there will be specialist market makers in the Algo community and generalists like us? Yes I do. We’re already in that world.”
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“Many are now finding that they actually had all those ingredients all along to become market makers. It was just a matter of how do we tell the model that we want to hold on to the risk” |
So what’s required to be a market maker? You need a view, you need to source liquidity, and you need to warehouse risk and put all those things together in a way that means you can sustain trading. While the traditional HFT business model has not been to make $100 million trades, neither has it been the banks’ business model, say some high-frequency traders, that is, unless they’re certain the client has no information on pricing. Mani Mahjouri, the former head of FX at Sun Trading, a high-frequency firm in Chicago, reckons that there are a large number of high-frequency firms out there that could hold $100 million or $200 million positions if they wanted to and could probably always raise capital and warehouse more. “They’re working towards that – it just hasn’t necessarily been their prime objective to date because the spreads in the high frequency have been so lucrative,’’ he says. However, he argues that while they might not have the balance sheet of banks, their advantage has been, and remains, their greater edge on technology. “Now with increased competition, and increased mastery of what the traditional trading style and technique is, many are now finding that they actually had all those ingredients all along to become market makers. It was just a matter of how do we tell the model that we want to hold on to the risk.’’
Some are sceptical about the possibility of making that work as a business model. “They have to be very careful,” says another global FX head. “Citadel tried it, Brevan Howard might be thinking about it. People invest in these businesses and they think that they’re investing in a certain intellectual capital, but what they suddenly realize is, that they’re investing in a bank, then they say they need a bigger return.”
Product integration
That’s where the balance tilts in the banks’ favour, because it is where the majority of their investment has been directed; a more integrated product suite. While regulators are unlikely soon to regulate the behaviour of high-frequency traders, if the equity markets experience is anything to go by, the reduction of slippage and continued investment in a broader product by the banks will make the difference between the winners and losers. Regulation is going to change the way banks service their clients.
While FX forwards and swaps have in the main escaped the clearing requirement under the Dodd-Frank legislation, banks might find that they will end up clearing more and cross-margining more than might have been originally expected because of the interconnectedness between FX and rate products. “You’ll also need an offering in post-trade services, around clearing, cash management, and cross-margining,” says Amrolia. “While historically these services haven’t been a prerequisite for success, beyond 2012 it will be important to be active in this space. We recognize this and are investing heavily.”
