When it comes to Foreign Exchange (FX) trading the Covid19 pandemic uncovered that for many institutional investors the crisis has presented a striking opportunity to improve their trading set-ups and best execution frameworks. At SchoeppeFX International Consulting we have seen an increased demand of clients in the asset & wealth management industry to identify and leverage additional potential for value creation and cost reduction. Market volatility and working conditions brought on by the pandemic created an environment necessary for further digitization, automation and innovation in FX trading across buyside organizations.
More than one year after Covid emerged, those competitors amongst asset managers, hedge funds, pension funds and corporates who had harnessed technology to their advantage remained more resilient and were able to stay ahead of the curve in transformational times. As a result of this pandemic shift buy-side clients across the globe are increasingly looking for updated means to improve quality, results and robustness of their FX trading operations across four focus areas where automation plays a key role: their strategic framework, operational set-up, innovative collaboration, and risk control.
Cost pressures weighing on buy-side trading operations stem from having to comply with an increasing global regulatory landscape, the ongoing shift to passive investing, and the compression of trading fees and spreads. A high percentage of the capital markets industry’s costs traditionally derives from its organizational and technological complexity, which built up over many years before the first Covid waves emerged. More than one year later this trend within the industry to break free of such legacy silos remains intact.
Analyzing the individual FX setup of our clients from scratch is the first key primary health-check element in order to subsequently establish technology and processes at a cutting-edge level across the FX value chain, covering all areas of interaction with clients, liquidity providers, portfolio management, operations, and compliance. During and after Lockdowns strategic business reviews across our target client base indicated clearly what has worked and what has not across front, middle and back office functions. In general, buyside clients tend to benefit from greater flexibility of their underlying trading business model if they treat FX as a dedicated asset class vs. only as a side-product of traditional asset classes like equities, fixed income or real estate.
The pandemic shift towards flexible working structures and working from home has forced institutional investment managers to rethink the way they assess trading platforms and FX service providers. Although most FX trading operations have been functioning well since the first lockdown, it is still frequently observed that a lot of digitization projects are carried out ineffectually without exploiting its full potential.
The decisive question for corporates and investment managers now is: do they just want to return to the status quo before the pandemic or are they able to significantly improve their trading set-up and best execution framework for FX? Winners of the future will sustainably invest in building a trading strategy and culture which ensures they can continuously enhance processes, technology and culture to sustainably optimize their cost model and return on investment.
Asset and wealth managers today want true flexibility in choosing the best partners for their FX trading and investment processes, which significantly contributes to long-term competitiveness. Taking the FX trading business to the next level requires new forms of cooperation with innovation leaders. As a result of the pandemic digital workflows and data transparency will partly or entirely replace the physical interaction between teams – including order and execution management, client service and idea generation. Proactively identifying this challenge will remain essential in the coming months and years. This also includes enhanced remote and mobile access to production and UAT trading, execution and settlement platforms. Innovative technology partners have the capabilities to integrate new tools and applications without trying to diminish existing set-ups.
Physical distance between various aspects of trading operations means increased complexity. Since the beginning of the pandemic buyside clients are continuing to adapt to the new market realities and have been reskilling its staff to apply new communication tools and technologies. Many of them focus on automating processes and enhancing decision-making processes using virtual environments. To streamline operations, workflows are becoming increasingly digitized, automated and well-defined. E.g. due to higher scalability and lower implementation cost, not only financial institutions of all sizes are turning to use more cloud computing.
On the flipside, our conversations with buyside traders indicate that remote working is reaching its limits. In such an environment many clients find it difficult to protect sensitive information, to maintanin in-depth client relationships absent personal contact, and most significantly, they are missing the the benefits of of shared culture, spontaneous interaction and information sharing fostered by the trading floor environment. In an industry called “the people’s business” these are essential features of fiduciary business attitude and success. That’s why asset managers need hybrid plans for bringing people back to the office face-to-face with an enhanced footprint.
Data & Controls
The buyside industry has demonstrated significant resilience during the pandemic in performing its fiduciary duties. Across the globe increased transaction reporting and operational compliance requirements are causing buyside firms to reassess systems and procedures they have in place. With the democratization of data and information, asset & wealth managers are increasingly leveraging additional datasets to drive their trading, portfolio management and settlement processes. For example, we have seen an ongoing increase in applying artificial intelligence (AI), machine learning (ML) and natural language processing (NLP) to create information advantages and enhance controls. Whilst AI has become widespread across the asset management industry as a whole, it is still underrepresented in its trading operations.
A firm’s data foundation is mission critical as outdated or ineffective foreign exchange transaction and risk controls can have fatal consequences for buy- and sell-side trading organizations. All cases of abuse in the past and present have indicated the importance of ensuring that no matter if retail or institutional business all FX trading policies and procedures must meet national and international regulatory requirements covering benchmarking, monitoring and reporting.
In this context digital transaction cost analysis (TCA) improves evaluating the quality of execution across various trading channels and liquidity providers accessing order and trade history, trade patterns, third party data, performance indicators and rankings. Since its inception as a quality-of-service tool, designed to enhance client relationships and prove best execution under MiFID, pre- and post-trade TCA functionality has increased both in its real-time interoperability and accuracy.
Operational Excellence through Automation
Mostly affected by these gamechangers is the operational set-up of clients. Various analyses of operational structures and processes in buyside FX trading have shown ongoing deficiencies in terms of automation and system integration. During the pandemic a lot of corporate and investment clients across the industry had to observe digitization gaps and areas of improvement in technology set-ups, cross- functional workflows and controls. Subsequently simplifying and automating FX trade flow allows for reducing execution cost by investing in scalable technology to eliminate inefficient operational processes. Additionally, Asset Managers will need to leverage technology further in order to to manage the myriad of changing trading protocols, new products and internal processes.
The key element for any fiduciary FX trading operation in this context is the selection, establishment and connection of an appropriate Order and Execution Management System (OMS/EMS) set-up as its technological foundation and basis for Automation:
An OMS is designed to support the investment lifecycle, which includes portfolio modeling, trade generation, cash management, and compliance modeling across asset classes. An FX order can be created for each cash flow event, which is then transmitted to a connected EMS. Depending on the asset manager’s IT strategy and budget, as well as on the system interfaces used (FIX protocol/web service-/file-based) and the fields and message types supported, an OMS can be connected to either multiple EMS’s for various specific asset classes and trading strategies, or to one multi-asset EMS. Alternatively, a combined OEMS software providing investment and trading functionalities can be used. The FX EMS is the FX trading desk’s main tool and gate to the market for executing orders at best efforts.
In a first step orders submitted from portfolio management can be divided into either active manual or automated FX tickets - depending on internal and external order determinants such as specific client instructions, ticket sizes, currency or broker restrictions, settlement or operational requirements. This differentiation determines whether the order needs to receive a manual touch on the buyside FX trading desk or not, the latter being classified as low-touch execution which has become the major flow type in FX.
In a second step based on pre-defined liquidity profiles and basket trading criteria within these two pillars, tickets can be either routed individually or in bulk as a request-for-quote (RFQ) to a sellside trading desk for manual pricing, as a request-for-stream (RFS) priced electronically by its price engine, or as an algorithmic ticket priced electronically by a bank’s separate algorithmic engine. Algorithmic FX suites offer a variety of fully automated liquidity seeking and time-slicing strategies including point-in-time or benchmark (fixing) executions which can significantly reduce price impact and execution cost.
In a third step after pricing the executed trades with the resulting account allocations are routed back to the trading desk and passed on to the back office for transaction processing, which is more and more supported by newer OMS/EMS solutions as well.
A final step presents the icing on the FX trading cake: Achieving a fully automated order routing (AOR) across the described order lifecycle through straight-through-processing (STP) applied at each stage, also referred to as ‘Smart Order Routing’ (SOR). The industry’s share of FX SORs and bulk orders continues to rise as they significantly contribute to defragmentation, transparency and efficiency of FX platforms and markets. Additionally, since last year we observed a significant buyside increase in the number and volume of trades using algorithmic execution strategies across G10 and Emerging Markets FX pairs.
FX next Level
In summary, automated trading platforms help modernizing the FX trading process to achieve a more consistent, rule-based and reliable workflow that draws on advanced execution, accounting and reporting/TCA tools, which support identifying and managing a competitive liquidity provision and price competition to ensure best performance in multiple trading environments and situations for the buyside. A digital route creates a quick solution for executing low-touch orders and allows FX teams to spend time on larger or more complicated trades. Smart OMS/EMS combinations additionally reduce the negative effect of FX market fragmentation on liquidity and best execution, and offer an effective solution for handling and evaluating the complexity of market protocols.
With the use of a data-driven routing technology, FX dealers can effectively implement modern trading strategies and make sure they are not harmed by inferior execution quality as a result of limited choices and connectivity. In addition to the described multiple platform layers of potential efficiency gains and cost savings across the various stages of the order and execution lifecycle, the increasing sophistication of OMS/EMS suites facilitates the progress of embedded and automated TCA control functionality for FX as well.
As a consequence, any business planning to shift back to their pre-COVID-19 way of operating FX trading business once lockdowns end will find it challenging to remain competitive for corporates and investment managers. Identifying and exploiting new potential for introducing cost and operationally efficient technology enforcing automation have become crucial for asset & wealth managers in a cloud- and remote-driven next-level industry environment to avoid disruption and secure sustainable competitiveness in Foreign Exchange trading.