By Audrey Blater Ph.D. senior research analyst at Aite Group
By Audrey Blater Ph.D. senior research analyst at Aite Group

Six questions that buy-side participants and vendors must ask in FX

While the onset of electronic trading has certainly created new opportunities, it has also dramatically increased challenges for all market participants. This Industry Report focuses on six questions that all buy-side players and their vendors must address to thrive under the new FX market order.

Figure 1. Six questions for buy-side participants and their vendors
Figure 1. Six questions for buy-side participants and their vendors

1. Dealing with limited screen real estate

Limited screen real estate prompts buy-side managers to optimize how they can aggregate liquidity across all FX products in one spot. Electronic execution choices can become complex given the execution method, disclosed versus anonymous trading preference, and instrument type (Figure 2). Some questions the buy-side must consider include:
How do I efficiently engage both disclosed and anonymous liquidity providers?

  • For FX forwards and FX swaps, can I use the same e-platforms that support spot FX?
  • Do all FX nondeliverable forwards have to be executed on a swap execution facility?
  • How do I keep FX options trading electronic? Is there a “manual” button (e.g., chat function)?
  • Can I have all FX futures/options on futures on the same screen?

The rapid electronification of over-the-counter FX markets has shifted liquidity to multidealer platforms. Although non-spot FX products remain mostly voice-driven, such as FX swaps and options, change is in the air as these instruments are seeing more screen time. FX solutions vendors are being challenged by this evolution as the buy-side demands greater e-trading functionality across a larger range of instruments.

To this end, vendors are not only being asked about the breadth of instruments their platform is capable of handling, but also what their product development pipeline looks like. The decision to develop more trading features rather than chat buttons will be a differentiator.

Figure 2. So many ways to trade FX
Figure 2. So many ways to trade FX

2. Depth of Algo bench and flexibility of trading business model

In a perfect world, aka “normal markets”, buy-side players look to increase their algorithmic trading capabilities. However, when times get tough, the need to fall back on “relationship” trading still matters. This dependency on market conditions provokes managers to ask vendors about the specificity of their trading model:

  • Do I have enough access to different variations of native algos, third-party vendor algos, or bank algos on my platform?
  • How do I access request-for-streams (RFS) or request-for-quote (RFQ) liquidity when market conditions warrant (e.g., principal bids) or when I have a sensitive order that I can lay off to a trusted bank counterparty to work via an agency arrangement?

Question 2 above deals with solutions to address different liquidity dynamics during different types of market conditions (e.g., flight to safety, flight to voice). It would behove solution vendors to engage in a dialogue with their buy-side customers by asking how important this flexibility is and scale their systems accordingly.

3. Attaining workflow efficiency

Market participants in all corners of the FX universe are constantly wondering how they might make their workflow as efficient as possible. After all, efficiency is a massive cost-saver – no matter the method of FX order placement (Figure 3). Buy-side managers in particular need to consider the following when streamlining pre-trade, at trade, and post-trade processes:

  • How does my electronic platform allow me to net my internal flow across all spot FX orders?
  • How does this same platform allow me to net my spot FX against outright forward FX orders internally, and then create residual spot and FX swap orders to trade externally?
  • Does this platform allow me to trade my residual spot FX, FX swap, and FX forwards orders on a disclosed RFQ/RFS basis, or do I have the additional option to trade them anonymously?
  • How do all completed trades on this platform flow through seamlessly into my order management system (OMS) for straight-through processing?

Beyond pre-trade and at-trade analytics and functionality, questions around the downstream integration of executed trade details can either improve workflow or become a burden for buy-side IT staff. Workflow optimization presents a great opportunity for vendors that understand the challenges inherent to the buy-side and can come up with innovative solutions. When managers are considering which set of characteristics constitute the best FX trading system, total cost of ownership (TCO) is often top-of-mind.

In addition to pushing vendors to prioritize superior trading capabilities as well as system integration and workflow efficiencies, Question 3 also points to the motivation of the buy-side to think about their current FX workflow and the benefits of internalizing FX flows. By proactively netting in-house orders before trading the balance with external FX market participants, optimization processes can reduce market impact, no matter what type of trading venue or price discovery method is used on those electronic trading platforms. Systems that can support this process will score high marks.   

Figure 3: Managing FX order placements
Figure 3: Managing FX order placements

4. Transaction Cost Analysis (TCA) and Best Execution obligation

Measuring how effectively a trade is executed in light of the best execution requirements set out in the revised Markets in Financial Instruments Directive (MiFID II) has driven a greater need for transaction cost analysis by FX market participants. Compliance with the rules coupled with the motivation to gain better insights into trading costs has led buy-side managers to think about TCA in relation to their trading systems:

  • How can this platform allow post-trade TCA reports to be displayed?
  • Can this platform provide pre-trade analytics so I can estimate market impact beforehand?
  • What about real-time TCA capability, with the ability to change my strategy on the fly?
  • How is the issue of “last look quote/pre-hedging activity” being examined within the platform, and what, if any, steps are being taken to incorporate FX Global Code’s recommended changes?

Question 4 above is really a call to arms for industry players to educate themselves on the benefit and use of FX TCA – beyond the MiFID II requirements. Asset managers should use the TCA conversation to educate and get buy-in from asset owners on what exactly is best execution for the firm.

As fund managers become more conscientious of their fiduciary responsibilities, their customers’ demand for best execution has given rise to a new industry in FX TCA. The momentum for buy-side firms to hire third-party FX TCA consultants or to build their in-house FX TCA studies with external help is a definite sign of FX TCA’s growing importance as a tool to validate best execution.

5. Alternatives to address liquidity shortage

Buy-side FX participants are looking to access liquidity beyond traditional means. The provision of liquidity by nonbank liquidity providers, retail aggregators, and peer-to-peer (e.g., other buy-side flows) via crossing networks is evolving. When thinking about ways to tackle the liquidity shortage, buy-side participants weigh the following:

  • What kinds of nontraditional pools of liquidity can this platform reach? Is it just for spot FX?
  • How can I access these nontraditional pools of liquidity anonymously?
  • How can this platform (and its FX prime brokerage partners) help make my life easier when onboarding the necessary credit and technology so I can start trading in the least amount of time?
  • How is this platform going about expanding FX liquidity aggregation by including FX electronic communication networks (ECNs) and nonbank sources of liquidity? What about liquidity in non-G10 and emerging market currency pairs?
  • How does this platform source liquidity across different time zones, and how many people are available via the help desk across the various time zones in a 24-hour marketplace?

Question 5 above is all about challenging industry participants, particularly the solution vendors, to think outside the box by opening up to more FX ECNs as well as nonbank liquidity providers. Going forward, the FX market liquidity landscape will require different types of liquidity providers putting through anonymous and continuous streaming prices akin to a central limit order book for an electronic market to perform its full function.

For buy-side players, finding alternative sources of liquidity also means being open to dealing FX with nonbank players. This can be achieved by trading anonymously via a central limit order book on a good liquidity aggregation platform with all sources of liquidity.

6. Multi-asset class functionality

FX does not typically live in isolation as an asset class at buy-side firms. As the trend towards more complex portfolios consisting of a broader use of instruments continues, FX traders are looking for ways platforms can help them evolve into a more diverse role and accomplish their firm’s goal of multi-asset, multi-instrument trading. In doing so, integration- as well as compliance-related questions pop up:  

  • How does this platform provide a smooth integration with whatever order and/or execution management systems (vendor or in-house) my firm uses?
  • How does this platform also satisfy all necessary order/trade compliance and surveillance engines that work within these systems?

Question 6 above addresses questions and issues around features that will become increasingly important, as multi-asset trading in the next three to five years will rapidly become the norm on both sell-side and buy-side desks. Only those vendors that can focus their efforts on better aligning their applications with client workflows along the entire order/trade life cycle will win. Furthermore, vendors are pulling away from the pack with combined order/execution management systems, rich mobility options, visualization tools, and reinvestment in their technology stack to take advantage of new growth opportunities.