The FX market has been hit with a broadside of changes that has fundamentally impacted the way investment managers access, trade, and do due diligence on the transactions they execute on behalf of clients. What was once a simple process of placing a request-for-quote (RFQ) on an electronic trading platform to a few different banks is now no longer good enough to meet modern day standards.
“There is an increasing realization that the buy side needs to take on more responsibility for its FX trading,” says Neill Penney, co-head of trading at Thomson Reuters. “If you look at the analysis done about buy-side trading under as a result of recent industry initiatives, one of the demands has been that the buy side needs to exercise greater due diligence on their own execution. There is a general drive if a firm is taking prices from banks on behalf of clients, it needs to defend the execution decisions it makes.”
This has been driven by a variety of factors, including the WM/Reuters benchmark scandal in FX which showed serious shortcomings in the handling of client orders at bank trading desks, which resulted in the release of the Global Code of Conduct by international regulators and signed by many in the industry to adhere to a new set of standards.
Other requirements have come in the form of more regulatory oversight, specifically the second iteration of the Markets in Financial Instruments Directive (MiFID II) which has placed best execution standards on all buy side firms executing in the FX market. This has been a fundamental shift that essentially requires asset managers, corporates and hedge funds to prove the logic behind every trade decision – an auditable time stamp.
“Today, both in light of regulations like MiFID II and the increasing availability of data and analytics, any firm would be considered a major outlier if they were not able to track and fully audit all trades and trading decisions,” says Christopher Matsko, head of FX trading services at FactSet, owner of Portware Enterprise. “Although MiFID II reporting for FX generally falls to either the SIs or MTF/OTFs, it’s the regulatory transaction reporting requirement which is absolutely driving the need for accurate, auditable, time-stamped trade data industry-wide.”
“New regulations are also focusing on enhanced investor protection,” says James Taylor, head of FX electronic market sales at Bank of New York (BNY) Mellon. “For example, under MiFID II, institutions must now take “all sufficient steps” to obtain the best result for clients on a consistent basis. Factors influencing the execution decision that need to be taken into account include the size and nature of the transaction, direct and indirect costs, speed, likelihood of execution and settlement.”
There is also increasing pressure on the asset management industry to keep transaction costs down for clients as the landscape becomes more competitive, not just the rise of MiFID II. This is also driving the need for best execution tools, according to Yazid Sharaiha, global head of investment strategies at Norges Bank Investment Management, the arm of Norway’s central bank that manages the world’s largest sovereign wealth fund. “The need for greater transparency is partially driven by new regulations such as MiFID II, particularly around best execution obligations,” he says. “More importantly, competitive pressures in the asset management industry require a greater focus on transaction costs, in our view. The difference between a top-quartile ranking and a second-quartile ranking often comes down to transaction costs. This means that transparency is not just a requirement from a regulatory obligation perspective, but also from a competitive perspective for the asset manager.”
A simple way to do meet some of these requirements has been to take a leaf out of the equities markets. Banks have been busy dolling out transaction cost analytics (TCA) to clients for a number of years, with the new regulatory and conduct standards set to boost demand. In FX, those data requirements can be complex, and are needed to fulfill two key functions, says Sharaiha.
“The data requirements fall into two categories: First there is an ‘audit trail’ requirement of executed trades – being able to reconcile how we got to a particular execution price and quantity. Second, there is data on the trading and routing infrastructure used by counterparties – how internalization works, how and where counterparties might route to other venues or liquidity providers and a number of other relevant factors,” he says.
Depending on the data you receive, the outcome for each asset manager could be slightly different, says Jeff Leal, global head of eFX at BNY Mellon. The order lifecycle time can also be a factor depending on the systems each firm has in place, he says, and can affect the rest of the trading process.
“The order lifecycle in some asset manager workflows can take some time to process. Once a trade reaches the executing counterparty it can take a sometime to process, depending on the complexity of the portfolio, but that is not the only factor in play. For instance, some clients use third party tools that haven’t changed for years. The data available to asset managers will greatly differentiate not only efficient processes from inefficient processes, but stronger data will also highlight pricing inefficiencies. BNY Mellon has focused a lot of its investment in the FX franchise on streamlining the execution process. I expect to see third party platforms and asset managers also looking at how new reporting requirements can focus their efforts on reducing the order lifecycle time,” says Leal.
Some participants feel an independent measure of execution is required when beginning to evaluate the data, and has seen firms jostle for position to take up that slack. For example, Thomson Reuters has teamed up with start-up TCA provider BestX, providing straight through processing of the platform’s trades from FXall to the vendor so clients can accurately measure the cost of their own individual trades.
“At Thomson Reuters, we’re the world’s leading provider of market data. Our BestX partnership is also good because they can use our market data to value trades against anything don’t across the market. Accurate market data is critical because if it’s wrong, then when you’re looking at a particular trade, you can’t make a good decision because the market data is bad. So you need a good picture of the entire market in-built within the TCA software,” says Penney.
FX has typically been long behind other asset classes like equities when it comes to measuring transactions costs. This is partly because the market has no consolidated tape to reference. This makes the use of reliable data to measure the TCA of any trade even more crucial when proving best execution to clients and regulators.
“Achieving the optimum execution outcome on a consistent basis will require ongoing evaluation, validating each stage of the process, identifying any deficiencies and remediating them immediately. In some cases asset managers may need to utilise independent quantitative analysis, such as TCA,” says BNY Mellon’s Taylor.
“For their part, trading platforms and data warehouses will need to capture significantly more regulatory data, such as trader identifications; LEIs and ‘reason codes’ to explain certain trades. Accordingly, trade ticketing screens will also need to accommodate all of the required data inputs at the time of trade,” he adds.
Some vendors have looked to make use of the best data systems they can get their hands on in order to give customers the best possible chance of ultimately getting the best price having done the transaction analysis.
EBS Institutional, a spin out platform from long-standing interdealer market trading venue – EBS Market – has been doing just that, according to the head of the platform, Simon Wilson-Taylor. He says in the unleveraged asset management sector, FX Connect is still the “800lb gorilla” because firms became entrenched with the firm’s technology over the past 20 years.
However, Wilson-Taylor believes that there has been catalyst for a new type of platform in the market from the new regulatory and conduct standards that require a better understanding of the market data requirements that asset managers need, and a solution that is built for the modern age of trading.
“The problem we were trying to solve with FX Connect was a messaging problem. We needed to know when an asset manager asked a bank for a price, that it was that bank responding and not another. That sounds fundamental but we needed to have a bullet proof messaging system. Other platforms that came later were trying to solve the same thing. Now we have data requirements, those same platforms are trying to bolt on data collections onto the side,” says Wilson-Taylor.
When designing the new system, the messaging element was easier by comparison. The more important requirement was for data and having that as the central tenant of the new platform.
“If we were going to do TCA properly, compliance reporting, and pre-trade analytics, then we needed to build this thing in the world’s biggest big data database, and one that is fast enough to be able to do sub-millisecond calculations. KX systems in California that produce the KDB database, is standard for big data and analytics tools for most investment banks. The New York Stock Exchange recently announced use of KDB for its new data products, for example,” says Wilson-Taylor.
Despite the advancements the FX industry has seen in TCA across the asset management community, it is still a relatively new concept for many portfolio managers and execution specialists compared to those in other asset classes in equities, where sophistication in TCA products has grown significantly more rapidly.
Market participants feel that a similar evolution will occur in FX TCA in the near future, helping asset managers continuously upgrade and adapt their capabilities to make sure they have the best tools at their disposal.
“I’m sure that we will see a growth in both pre-trade, real-time and post-trade analytical tools, as traders attempt to utilise the enhanced data and transparency available to them,” says Taylor.
“The next innovation that the industry needs to adopt is more advanced TCA,” says Thomson Reuters’ Penney. “Every bank will provide a TCA report with any algorithm, and every bank’s TCA report will say their algo is the best. But what’s needed is, and has yet to come, a sense of standards. We’ve partially solved this by our customers investing in a single independent view of how each algo performs, which is the BestX product, but the buy side is very different – some will be sophisticated and others need a set of standards to follow.”
Algorithmic FX trading
The focus on data-driven analysis has been helped by the rise of electronic trading, which has in turn seen a steady uptick in algorithmic execution versus trading over the phone. Given the FX market updates multiple times per second, the benefit of being able to execute via an algo is much quicker than trading over a phone, while it also helps to give an accurate timestamp of a number of different transactions.
The rise in this particular toolkit has been motivated by both the banks themselves, as well as the asset managers. Certain legal cases against FX traders have shed light on the execution practices taking place at some banks and meant some institutions are not willing to do entire risk transfer orders over the phone now.
“Asset managers that used to be able to phone a bank with a large trade aren’t able to do that now because banks don’t want to receive those orders on the phone anymore. Bank traders may price some of the trade but might work the rest algorithmically. So they sell an algo to do that and then it becomes purely systematic,” says Wilson-Taylor.
“Electronic trading tools are being thrust at the customers right now, so we’re seeing a demand from the buy side because many of them are very confused by what has happened to them. Now buy-side traders need to stage orders and need a different kind of system, one that can receive orders, analyse them, group them, net them, look at pre-trade expected cost and make a decision on what instrument to use,” he adds.
FactSet’s Matsko says that many of the algos on offer from banks are seeing a great deal of interest from clients, particularly on a hybrid basis.
“There isn’t a great deal of interest from the real money community in what we would consider pure ‘agency’ style executions. However, we are seeing much more interest in and usage of bank algos. More and more we are seeing clients interested in interacting with the primary markets more as passive participants, either through said bank algos or directly through the use of credit carve-out agreements. They aim to lessen market impact, and possibly save on costs by getting lifted out of a position at a mid-rate versus crossing the spread,” he says.
BNY Mellon’s Leal has also seen clients increase algo execution, which helps achieve MIFID II best execution where required given the fragmentation of FX platforms and liquidity in the market today.
“We see asset managers increasing their use of execution algorithms. Execution desks are always looking to improve their performance, but accessing a single provider in a risk price is not always the most efficient approach. If the trader is instead able to access a range of venues and providers – which may include that provider’s principal liquidity - and demonstrate their performance through data, that may greatly improve their execution outcome,” says Leal.
The more algo execution that takes place, the greater the rise of agency-style execution, too. Thomson Reuters’ Penney says there is a lot more agency trading that asset managers are taking advantage of, and the algo use – given its ability to leave an audit trail – encourages money managers to experiment more with new trading strategies.
“Absolutely going up – algo usage is increasing on our platform and we know from our banks that other platforms are experiencing the same, with a number of factors driving that. Algo trading gives proof of best execution, so it’s compelling for asset managers wanting to experiment with different trading strategies, mixing algos and pure RFQ,” he says.
Sharaiha believes that TCA is easier to measure more accurately within an agency-style execution strategy versus a principal one. “In an agency framework, there is increased scope for algorithmic execution styles, with the associated pre- and post-trade TCA. If this separation does not happen, and algorithmic executions are still wrapped in a principal transaction, doing a proper TCA will be more difficult,” he says.
One thing seems certain – the more electronic trading, the more able asset managers will be to cultivate the data they need to analyse, report and prove best execution on transactions than they ever would have been able to in the past.
“With our clients trading FX through Portware Enterprise, we are seeing a strong feedback loop between the uptake of electronic trading; the data electronic trading both requires and creates; and the organizational desire for more data, analytics, and open workflows that grows with experience. In other words, the demand for data is augmented by, and will almost certainly drive further use of, electronic trading. Automation and advances in multi-asset trading technologies and workflows will, in my opinion, have a profound impact on the continued uptake of e-FX trading, while also providing the buy-side with meaningful data points around cost, speed of execution, and holistic pre-/post-trade analytics,” concludes FactSet’s Matsko.