Andy Woolmer
Andy Woolmer

The role of independent data in meeting regulatory obligations and helping to manage FX costs

It is important that asset managers are asked to measure their FX transactions against independent data to eliminate any accidental flattering of FX costs by managers. Once the costs are determined it is then a relatively simple task to begin managing them. The most important thing to recognise is that paying too much for FX, delivers no additional benefit for buyside firms whatsoever. It’s simply a drain on their portfolios. e-Forex spoke with Andy Woolmer, CEO of New Change FX, the award winning FX data company to learn more about measuring and managing FX costs.

First Published: e-Forex Magazine 87 / ALGOFX LAB / July 2019

Why are FX costs impossible to measure accurately without using independent, aggregated data?

FX prices are bespoke. Liquidity is fragmented across market makers and venues. Even when venues can offer anonymous streaming prices, liquidity providers widen their spreads for non-disclosed trading. This means that prices are either adjusted as a function of who the client is (for disclosed trading) and/or adjusted on a generic basis (for anonymous pricing). To identify how much prices received are skewed away from the market clearing price one must use an aggregated rate (to reaggregate fragmented liquidity) and independently of the trading venue, to measure the skew.

Why does spread alone tell you nothing about your costs?
 
Spread is in fact a crucial measure of cost, but it is far from the whole story. Market Impact costs dominate. Empirical client data from sophisticated hedge fund clients shows market impact costs are on average 2.5x spread costs. This means that liquidity providers (LPs) can discount spreads to close to zero for flow because the business model of market making has evolved beyond simply charging a spread to take on risk. LPs are better at monetizing the flow by clearing positions at a favourable price seconds or minutes later.
How easy is it for asset managers to get their FX transactions measured against independent data and what’s involved with the process?

Measuring trades against independent data is straightforward. The challenge for Asset Managers is to ensure they are capturing all the relevant timestamps in their trading process.  NCFX have simplified this by working with asset managers to automate the TCA process. NCFX does not require access to client data. Clients can compare brokers and platforms against the same independent rate, safe in the knowledge that their data is secure.

What does managing FX costs usually entail and in what ways is it more than just achieving better execution?

Managing FX costs means identifying the drivers of FX cost. The constraints of the portfolio mandate determine the trade-offs that arise. The goal of TCA is to determine whether these trade-offs were efficient, providing critical feedback to adjust the mandate if it is needlessly wasteful of client capital.

In order to manage costs some FX trading firms take advantage of so called “free” TCA services. What is the rationale for choosing to pay for a TCA service that is external to trading and how can this help to remove any conflicts of interest?

As they say in Silicon Valley, if the product is free, then you are the product.  Because ‘free’ TCA is generated from inside the cost chain, it cannot identify costs that are endemic to the trade process itself. The power of independent services is that they enable a comparison of trade processes against an external reference. Free TCA assumes there are no alternatives to the execution set up currently in place.

Managing FX costs means identifying the drivers of FX cost
Managing FX costs means identifying the drivers of FX cost

What sort of granular metrics can the latest generation of TCA toolsets now provide and what degree of automation is possible?

We now provide live benchmarks (every 50 milliseconds) into trading systems, so clients can monitor execution on a benchmarked basis in real time.  The execution policy can then be assessed ‘in flight’ by an automated system to ensure compliance.

How can thinking about market impact help firms leverage TCA in order to be more discriminating in their approach to FX trading and what impact on costs would this have?

Trading in high impact venues, or with brokers that have high impact is very costly indeed.  Identifying market impact and how it differs across venues is a crucial first step to cost reduction.

It is well known that traditional FX benchmarks have presented problems for investors but what attributes does a more meaningful benchmark need to have in order to meet regulatory requirements and what would it rely on?

The purpose of benchmarks is to provide a fair value for comparison. Benchmarks need above all to provide price transparency, and the process that determines the benchmark must be fair.

Regulators now demand the inclusion of surveillance capabilities that cover all scenarios including data sources.  How much of a challenge is this for FX trading firms and in what ways can the use of truly independent data assist them with their monitoring requirements?

Because FX prices are bespoke and fragmented, the challenge for FX trading firms is to identify anomalies in prices that are endogenous to the client’s trading process. NCFX provides a simple way to assess whether quoted prices are within specified parameters.  

What factors are encouraging more banks to look at using the NCFX regulated mid rates?

Banks need to show they are treating customers fairly. Transparency encourages participation which is vital for a healthy FX market, which in turn will generate increased readiness amongst clients to fully hedge, driving additional flow for the banks.