Improving execution in complex markets
The FX market is undergoing significant change. The speed of execution, increased amounts of market data and more fragmented liquidity means achieving and demonstrating best execution is more difficult today than it has ever been. Simultaneously, there is more pressure to minimize market impact and reduce information leakage. These trends make the job of any FX investment manager more difficult.
Driven by these challenges, the industry has seen growing adoption in execution algorithms. While early FX execution algorithms were limited to automating relatively straight-forward trading instructions and traded on one venue, the technology and logic underpinning algorithms has advanced significantly over the past decade as the FX market has evolved.
Execution algorithms render a complex market structure into a simple, more manageable market for the trader. A human cannot react as quickly to changing bid/offers across multiple venues as quickly as a computer can.
A high performing execution algorithm will assess the current market situation, and the the available sources of liquidity at a given point in time. After analyzing this information, it will select the optimal routing decision and execute a trade in the most efficient manner while minimizing market risk – all without the involvement of a human. This has the benefit of demonstrating best execution requirements to an investor.
Additionally, since algorithms automate trading, they enable traders to handle multiple orders simultaneously. This is another important advantage, especially at a time when traders are being asked to do more with less.
As a result, more and more investment managers are providing algorithm-based strategies to their clients, accounting for approximately 20% of all institutional FX trading volume.
In a study by Greenwich Associates, 58% of FX traders found that algorithms materially reduced overall trading costs, while over a quarter of traders believed algorithms enabled them to spend more time on complex orders. This is a win-win for investment managers’ trading desk as well as their end-user clients and investors.
Navigating the regulatory maze
Last year’s introduction of MiFID II significantly upped the stakes for best execution, because firms must now take “sufficient steps” to ensure favorable execution of client orders as opposed to “reasonable steps”.
This change in language may sound subtle but it has significant consequences for investment managers. Each firm must now have a clearly-worded best execution policy that has sufficient detail for its clients. In addition, the effectiveness of this policy must be analyzed at least once a year.
While MiFID II’s rules covers equities, OTC derivatives and listed products, spot FX falls outside its purview. However, industry practice has seen the majority of firms treat spot FX as if it were part of MiFID II. Thus, traders follow the same policies and procedures for spot FX as they do the assets and instruments covered under MiFID II.
At the same time, greater attention has been placed on complying with the principles of the FX Global Code. One of the Code’s six principles is Execution, which outlines a set of principles clarifying what traders should expect from their service providers, as well as the processes and policies they should have internally around trading in order to promote fair and orderly markets.
With the changing face of regulation within FX, it is important for all participants to realize this importance and ensure that their business model and products correlate firmly with this. Responsible investment managers typically tackle this challenge by building a clear framework in which an execution policy is designed, built and used to benchmark execution. One of the primary data inputs into this framework is transaction cost analysis (TCA).
By its nature algorithmic trading lends itself well to TCA, as the market data needed to power the algorithm can be logged in a database, along with the execution data. This enables investment managers to easily measure and understand the quality of their execution against a variety of benchmarks like the arrival price or sweep-to-fill price.
For trades that were traded quickly and with more urgency, it is also easy to see the price reversion after the trade. This is an important consideration in TCA.
A more sophisticated future
Algorithms will play a central role in the future of a rapidly modernizing and increasingly regulated FX industry. As the market gets more sophisticated, FX investment managers will become more experienced in assessing the algorithms available to them against a critical set of benchmarks, such as those outlined above. In turn, they will gain comfort with controlling their order flow through the use of algorithms.
This will have positive implications for all parties involved, including the regulators demanding more transparency, the investment manager that must prove best execution, and the customers that want to know their capital is being invested in the most effective manner.
An algorithm’s ability to source liquidity from a fragmented market, reduce trading costs and market impact, and increase an investment manager’s efficiency will secure their position in the FX market of tomorrow.