The global foreign exchange (FX) industry has gone through quite a transformation over the last 40 years, both from a market infrastructure/market dynamics perspective and as a result of rapid technological advancement in communication mediums and trading venues. Gone are the days of the 1970s, when telex machines and telephones were the only communications tools available. In that era, sell-side banks held all the power, because they were the sole liquidity providers to each other and to their customers in a closed ecosystem. Since the start of the new millennium, the world has become increasingly dependent on internetspun technology, as various independent software vendors (ISVs) have brought electronictrading platforms of all shapes and sizes to the FX industry that first got its footing in the equities arena. The playing field nowadays in the FX industry has become more leveled. Sell-side banks, proprietary trading firms (especially highfrequency trading [HFT] firms), hedge funds/commodity trading advisors (CTAs), retail aggregators, corporates, and buy-side asset managers all play a crucial role in liquidity provision for an increasingly fragmented marketplace. A front office, multi-asset trading and analytics Execution Management Systems (EMS) platform has become a necessary solution to navigate an increasingly complex investment landscape.
Adding to this complexity in market infrastructure, the global financial crisis years of 2008 to 2010 brought elevated volatility across all markets, increasing regulatory scrutiny. The crisis also brought lower returns in traditional asset classes, such as stocks and bonds, which has continued into recent years, during which interest rates have been artificially suppressed by coordinated quantitative easing by all the major global central banks. Such a low return environment has elevated FX as an alternative asset class, where buy-side firms are now seeking to extract alpha in addition to mitigating risk. For institutional investors and their asset-owner clients, managing an international investment portfolio’s FX risk has moved from a peripheral job relegated to middle-and back-office personnel to a core trading desk function that requires skilled market professionals.
HISTORY OF FX TRADING THROUGH THE AGES
The FX industry came about when the modern era of floating exchange rates was introduced, wherein most major currencies float against other major currencies, subject to governments’ verbal guidance and sporadic intervention in markets. This new era started in 1973, when the Bretton-Woods Agreement was abandoned, a system of mostly fixed currency exchange rates that had been in place since the end of World War II.1
The media of trading FX preferred by industry participants have evolved from manual to electronic methods since that fateful time in 1973, and they will go the route of multi-asset EMS platforms in the upcoming years.
The following is a brief description of the tools chosen by institutional FX market participants (Figure 1) over the past four decades, as well as a prediction of what the upcoming decade may present:
RISING MARKET VOLATILITY, ONUS FOR BUYSIDE TO MANAGE FX RISK
For institutional investors and their asset-owner clients, managing an international investment portfolio’s FX risk has moved from a peripheral job relegated to middle- and backoffice personnel in the early part of the new millennium, to a core trading desk function that requires skilled market professionals since the global financial-market crisis years of 2008 to 2010. To properly manage the elevated FX market volatility since those harrowing years, the trading and analytical tools that institutional investors have chosen to use have also changed with the times. These changes are also in line with how both sell-side and buy-side firms are thinly staffing their trading units post-crisis.
MULTI-ASSET TRADING DESK QUICKLY BECOMING THE NEW NORMAL
Technological advances, changing capital markets industry dynamics due to competition, and regulatory reforms ever since the late 1990s all combined to revamp the equities market structure, which led to the growth of the EMS industry. Since the aforementioned global financial market crisis years, sell-side banks have relinquished more of their market-making obligations in over-the-counter (OTC) market dominant asset classes, such as FX and fixed income. Their balance sheets shrunk, and regulatory capital requirements became more stringent. The electronification of capital markets beyond equities means banks are increasingly shifting their business model to more fee- or commissionbased agency, rather than being principal market-makers and taking on more inventory risk in the products they trade. By the same token, they are slashing their headcounts in every OTC asset class and derivative instrument’s trading desk, and they are increasingly transforming into multi-asset class, multi-instrument agency brokering service units.
Today, the more progressive buy-side firms operate under the mindset of controlling the total cost of ownership when it comes to their investment management department. This has translated into hiring fewer traders on the trading desk and holding them accountable for trading across multiple asset classes, instrument types, and markets across more regions around the world. It also means limiting information technology (IT) and operational support for multiple systems and, to a great extent, cutting back on singleasset, best-of-breed FX trading platforms and substituting that with multi-asset and multiinstrument order management system (OMS) and EMS platforms. At Aite Group, we feel this shift will become the “new normal” for most buyside firms as we approach the 2020s. This is especially true with the anticipated European Union (EU) rollout in early 2018 of the new Markets in Financial Instruments Directive (MiFID II) rules aimed at research-commission unbundling and the associated requirements that money managers and their brokers must follow best-execution guidelines in every asset class and for every instrument type they trade.
ALGORITHMIC TRADING ON THE RISE
A good deal of the rise of electronic trading over the last few years was attributed to gradual adoption of algorithmic FX trading, driven by increasing interest from money managers and corporations. As the industry sorts through various regulatory changes in the coming years, the demand for execution tools that can provide more transparency and better performance than the traditional custodian-based execution methods will become even greater, and FX algos are expected to play a key role in this change in traders’ preferences (Figure 2).
BUY-SIDE INTEREST IN ALGO TRADING OF FX CONTINUES TO GROW
Aite Group has continued to periodically keep tabs on buyside firms’ interest in algorithmic trading of FX via various buyside survey-based FX focus research reports over the past four-plus years, particularly as this group of customers expanded its use of multi-asset OMS and EMS systems that have integrated algorithmic trading capabilities. A Spring 2012 survey-based report2 showed an adoption rate in the low teens for algo FX trading via multi-asset OMS/EMS. By our spring 2015 report,3 however, it was heartening to see that the same adoption rate had risen to a percentage in the upper 20s.
Most interestingly, as spring 2016 survey data is gathered and analyzed for a buy-side trading technology preference report to be released sometime in early 2017, Aite group has found that, among those respondents’ firms that are already deploying a multi-asset OMS and/or EMS solution, the percentage of firms that has adopted algo trading in FX has gone beyond 50% (Figure 3). Even more impressively, 11% of this survey’s respondent firms are conducting 75% or more their firm’s FX trading activity via third-party, broker-provided algos in multi-asset OMS and/or EMS platforms. The latest data further validates our assertion that not only is buy-side adoption of algorithmic trading in FX becoming a reality, but it’s also more pronounced at firms that use multi-asset OMS and EMS systems as their primary trading tools.
Algo trading in FX will continue to grow strongly among buyside firms in the upcoming decade, particularly as the FX market becomes even more electronic and fragmented and as aggregation of liquidity becomes a focal point of all electronic trading platforms. The task of buy-side traders seeking to fulfill best execution among fragmented markets in the 2020s, not just in FX but also across other asset classes and derivative instruments, will become a bit easier through the increasing usage of multi-asset OMSs and EMSs equipped with robust algorithmic trading and smart order routing strategies, together with real-time data analytics and sophisticated TCA tools.
BEHOLD, THE NEW SURVIVAL ROADMAP FOR THE FX BUY-SIDE
Currency movements are diffi cult to predict, but with the right risk-management framework and personnel, a buy-side fi rm can become very competitive in the industry. It’s too important a risk to neglect: As fi nancial markets become increasingly global, mismanaging or, worse, ignoring currency can often impact a buy-side manager’s absolute and relative performance rankings on a short-, intermediate-, and even a longterm basis. Investment performance is too important to be overlooked, as that’s the only objective measure of a buy-side fi rm’s true worth to the marketplace in the long run.
DON’T BE AN OSTRICH—STICKING YOUR HEAD IN THE SAND IS NOT THE ANSWER
Complacency and ignorance are no longer excuses, and buy-side asset managers must realize that they too have their own customers, to which they will increasingly be held accountable for fulfi lling best-execution obligations in a research-commission unbundled environment after the launch of MiFID II (as early as January 2018). Gone are the days of asset managers’ old “head in the sand” attitudes. No longer can they leave their sell-side counterparts to fi gure out all the nuts and bolts of regulatory changes and expect them to inform their buy-side customers of what they need to do. A proactive rather than reactive approach toward anticipating regulatory, technology, and market structural changes is the key to one’s long-term survival.
1. David Wessel, “A brief history of Exchange Rates,” Wall Street Journal, July 22, 2005, http://www.wsj.com/articles/SB112195084191892053, accessed August 23, 2016.
2. See Aite Group’s report Buy-Side FX Outlook: In Search of Best Practices, March 2012.
3. See Aite Group’s report Buy-Side FX Outlook 2015: Measuring Up to Best Execution?, March 2015.