Research published by Greenwich Associates last year referred to the increasing use of algorithms and predicted that penetration would rise to 18% of institutional investors by the end of 2014, up 64% from 2013.
| As long as the corporate treasurer is comfortable paying a volume charge, algorithms optimize spot transactions|
While just over one-third (34%) of all firms’ FX volumes were executed using algorithms, and the figure for hedge funds was 53%, the Greenwich report found that corporates executed only 3% of volume via algorithms.
Hedge funds use algorithms for direct market execution. There are also some pension funds that actively use algorithms in the FX space because they are mandated to show best execution, explains one analyst.
“Algorithms tend to be used for trades that would move the market by institutions that don’t want to show their hand,” says the analyst. “However, corporates would not be taking the sort of sizeable positions that would have this impact.”
In the past, banks would have had hundreds of spot traders. Now they have just a handful – plus a huge team of quantitative mathematicians who devise their algorithms, observes John Horlock, director CFDs at ADS Securities.
“This was always going to effect the smaller institutions, such as FX brokers and spread-betting companies, who use their flow to derive their FX prices and to hedge out accordingly.”
The technology to execute algorithmic trading is now widely available and many of the large real-money institutional investors and those who trade FX frequently – especially intra-day – have the appetite to invest in the necessary technology, says Sassan Danesh, managing partner Etrading Software.
According to Danesh, the challenge for corporates is not the technology, but rather the controls and processes required to ensure best execution.
“Slicing and dicing a large order into a series of smaller ones and managing each order to completion, with appropriate auditability and validation of best execution, is significantly more onerous than passing one large order to a sell-side,” he says.
“Additionally, the use of algorithms by most buy-side is to allow the buy side to capture more of the bid-offer spread, but at the expense of losing the immediacy/certainty of execution. Those on the buy side who require immediacy/certainty of execution have less reason to move to algorithmic trading.”
Jim Cochrane, director of ITG’s transaction cost analysis for FX, agrees that large institutional investors are increasingly using algorithms for larger FX transactions.
He says ITG does not believe that algorithmic trading increases market risk in the FX markets, and other than meeting commitments to trade directly with a bank to cover the cost of borrowing funds for operations, there is no reason why a corporate might be reluctant to use algorithmic trading.
|Source: Greenwich Associates. |
Note: Based on responses from
1,127 FX users globally in 2013
ADS’s Horlock adds that corporates are less likely to use algorithmic trading because they generally have to use the daily fixes to buy and sell their currency, so they have a fixed point to show they are not just trading the markets and do not have the necessary flow for algorithms to work favourably for them.
“If anything, algorithmic trading significantly decreases market risk as most algorithms are programmed to hedge out every trade for tiny profits and cut any losing trade,” says Horlock.
“Also, it takes away the human element where many inexperienced traders run losses much further than they ever run their profits.”
Danesh reckons the key risk is in the ‘herd mentality’ that can be generated by having many market participants deploying similar algorithms that end up generating the same buy/sell trading signals at the same time.
This risks exacerbating and reinforcing any market movement, although typically only for a short, intra-day period.
As a result, corporates are reluctant to use an algorithm for execution without a thorough understanding of the risks involved.
“By executing an order over a longer period of time, a corporate takes on market risk during this time in exchange for some anticipated benefit,” concludes Kwiatkowski. “Transaction cost analysis can assist corporates in evaluating if improved execution cost is worth this additional risk.”