FX robots poised to execute voice brokers

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Algorithms are set to become the norm for FX execution among institutional investors such as pension funds and corporates, and the change may come quicker than many expect.

Long-established as standard practice in the equity markets, algorithmic execution strategies allow computer driven models to conduct trades on behalf of customers. Adaptable according to market conditions and investor risk appetite, they are programmed to minimize market impact and costs. The move towards using algorithms as execution tools in the currency markets is being driven by an increased focus on transaction cost analysis (TCA) within the FX sector. A number of high profile lawsuits in recent years involving US pension funds and their dissatisfaction with the FX pricing they were receiving from custodian banks highlighted the need for more scrutiny among institutional investors over currency pricing. There are, however, now other forces that are driving the shift towards FX TCA among institutional investors. James Wood-Collins, chief executive officer at Record Currency Management, says one factor is the increasing level of attention being given to cost savings across a broad swathe of investment activities. “Cost savings are quite rightly being seen as increasingly important in a low-yield, low-return environment,” he says. “Ways to save on all sorts of execution costs are seen as increasingly important.”
James Wood-Collins
Crucially, the changing structure of the FX market is also enabling TCA. TCA has always been a challenge in foreign exchange, due to the disaggregated nature of the market. A web of bilateral relationships, unlike the equity market, there is no consolidated “tape” in FX that reports the best bid and offer available. However, Wood-Collins says the increasing prevalence of trading through electronic platforms is enabling FX TCA in a way that was impossible to achieve even a few years ago. “The rise of electronic platforms has pulled many participants liquidity and transactions to the same place,” he says. “That has allowed an increasingly good proxy for a total market view to emerge.” There is still no one venue where every FX transaction, or every liquidity offer, is reported, but there are platforms that have an increasingly large share of transactions, allowing the transparency necessary to drive TCA. A recent survey by Greenwich Associates found that TCA for FX trades increased to 33% in 2012 from 28% in 2011, with 41% of institutions with more than $20 billion in assets using the analysis. That figure is expected to keep growing, with peer group analysis prompting a shift towards the use of algorithms as a means of FX execution. Jim Cochrane, analytics director at financial technology provider ITG, estimates that between 5 to 10% of institutional investors are now using algorithms to execute FX trades. When peer group analysis reveals the extent of the cost benefits that those early adopters are receiving by using algorithmic execution, Cochrane believes the move by the rest of the industry towards using algorithms will be sudden. “When institutions ask why some of their peers are in front of them and the answer is algos, the move will be lightning fast,” he says. “The switch to algorithms will be practically overnight.” Traditionally, in the FX market, there has been a belief that large orders are best executed by voice. Indeed, there has been a premium towards banks having a chief dealer that could work an order for a client anonymously and without causing a ripple in the market. Now, however, an algorithm can achieve that result, reducing the spread that investors pay to trade. That is not to say banks and other liquidity providers will be losers from this shift. Indeed, it could be considered a win-win scenario for liquidity providers and clients. Banks can charge customers for the use of algorithms that they have built in-house and benefit from the resulting flow. Clients, meanwhile, receive a better fill rate by letting an algorithm work a trade in the market rather than just accepting the best price on offer at a particular point in time. It may result in something of a seismic shift in the way that institutions access FX liquidity, but the use of algorithms has long been standard practice in the equity market. Cochrane believes that ultimately institutional investors in FX will recognise that over the long term, algorithmic execution is superior to voice execution. “You can try and beat the algo and sometimes you just might, but over the course of thousands of trades, the algos are going to win,” he says. “It’s more efficient and it is proven in the equity market that it is more efficient.” With the rise of TCA in the sector, institutional FX investors should begin to wake up to the benefits of algorithmic execution.

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