For those unwilling to accept any meaningful execution risk on their FX trades, trading on a risk transfer price with a dealer is the way to go – but there can still be a place for algos.
Despite broad acceptance that they introduce a measure of execution risk, as noted by a recent Bank for International Settlements (BIS) markets committee report titled FX Execution Algorithms and Market Functioning, market participants often reckon this downside is comfortably outweighed by the benefits.
Execution algos provide traders with more direct control & parameterization of their execution
Daniel Chambers, BidFX
“All traders need to understand the trade-off between reduced market impact and added time risk,” says Daniel Chambers, head of data and analytics at BidFX, an FX trading solutions provider.
“Execution algos provide traders with more direct control and parameterization of their execution.”
On top of that, end-users can in many cases tolerate much more variance than dealers, and can therefore take more time with execution, minimizing market impact and improving execution quality.
The trend towards a hybrid FX market structure has been going on for a number of years, with an increasing proportion of flow – mostly in spot FX – now traded with end-users taking more ownership of the execution risk.
“The rise in the use of algos is an example of this,” says Pete Eggleston, CEO of BestX, a transaction cost analysis specialist.
“But there are obviously pros and cons to all execution methods, and it is generally sensible to have a best-execution policy that allows an end-user to access the full menu of methods, from principal voice trading with a dealer, to direct market access and the working of orders.”
Liquidity indicators
Where market participants generally agree with the BIS is its suggestion that liquidity indicators will need to evolve to reflect the growing importance of rapid liquidity replenishment.
Execution algorithms tend to slice orders into smaller clips, meaning that the top of book is executed on, as opposed to requiring more of the market depth. The rate at which each liquidity provider replenishes this top of book varies – and depends on a few things, including internal flow.
“If you are going to give end-users the tools to control their execution, they will quickly demand information to drive their use of these tools,” says David Cooney, CEO of MahiFX, an FX and metals-focused fintech. “Liquidity indicators are a part of that.”
Communication with liquidity providers is just as important in bilateral, disclosed trading, according to Chambers at BidFX.
“Dialogue and the sharing of information facilitates much better flow for both sides, but is often neglected when it comes to electronic trading,” he says.
If the only source of liquidity is a primary order book … it makes more sense to look at liquidity over a longer period
Vikas Srivastava, Integral
The curation of liquidity pools and venues is largely the domain of the sell-side within the FX market, so the analysis and monitoring of rapid liquidity replenishment is generally more of a priority for these institutions.
“Real-time views of liquidity across the fragmented ECNs [electronic communication networks] is clearly beneficial when it comes to optimizing a smart order router,” adds BestX’s Eggleston.
“However, for the majority of the buy side, this is not yet a high priority, although it may increase in importance if more control over liquidity curation is transferred.”
Carlos Gomez Gascon, JPMorgan’s head of macro algorithmic execution, agrees, adding that the measure of liquidity is not just spread and depth of book, but also market resilience.
However, some argue this is true only in the context of primary market order books.
“If the only source of liquidity is a primary order book, then instead of simply looking at its depth at a specific time, it makes more sense to look at liquidity over a longer period, to get a broader view of how fast the liquidity is being replenished by certain algo-driven orders,” suggests Vikas Srivastava, chief revenue officer at Integral, a cloud-based eFX platform.
Execution data
The BIS report also noted that execution data remains costly and difficult to obtain, but there is little optimism that open access to a minimum set of data will become a reality any time soon.
The fragmented nature of the over-the-counter (OTC) market for FX means that all data regarding volumes and executions are estimates based on extrapolation from a smaller part of the overall market.
“Due to the difficulties and expense involved in creating a robust, meaningful ‘tape’ for executions that captures a sufficiently significant section of the market, it seems unlikely that there will be anything available for free,” says Chambers.
A further challenge is that most, if not all, large institutions would not want their executions posted anywhere, whether in real-time or with a delay, even if anonymized.
Since the larger players have enough data to provide a representative sample, they have little to gain from a consolidated view.
“The data for each bank looks different because of a lack of data standardization across dealers and also as a result of the OTC nature of the markets,” adds JPMorgan’s Gascon.
“Therefore, standardizing the meaning of the data metrics – even if they refer to different sources – would be beneficial.”
