Voice, Electronic, Hybrid – Exploring the alternative trading models for FX broking

December 2021 in Trading Operations

Electronification holds immense promise for execution but is FX immune to its charms? Vivek Shankar investigates.

Electronification has long been a trend in the institutional markets. Generally speaking, electronification is a natural part of market maturation and aids in growth and stability. Despite the FX market’s unique nature, electronification has increased steadily as technology has given market participants more choices.

FX is a deeply fragmented market. A 2019 BIS working paper highlighted that traditional inter-dealer and dealer-customer segments have blurred over the years, thanks to more execution choices. Despite fragmentation, the BIS noted that electronic execution was increasing.

A Coalition Greenwich study that analyzed trade execution methods from 2007 to 2020 confirmed this observation, noting that electronic trade proportions rose from 43% to 78% during that time. However, electronification has seemingly hit a plateau that even the COVID pandemic couldn’t overcome.

Stephen Bruel, Head of Derivatives and FX, Market Structure and Technology at Coalition Greenwich, states that COVID in fact increased the need for voice trading. “The market definitely increased the use of voice trading during the COVID induced market volatility as relationships and market color mattered,” he says. “But we also see that the broader adoption of algos continued during the pandemic, and that growth will persist; 70% of respondents to a recent Coalition Greenwich survey believe the use of algos in FX will increase.” 

Voice trading has long served as an alternative to electronic execution, and traders are unwilling to let it go. What does this say about hybrid voice and electronic broking models and where trade execution is heading?

Why traders love voice

Given technological progress, it seems odd to say that many institutional FX traders prefer voice-based execution. Coalition Greenwich’s 2020 Market Structure and Trading Technology study revealed that 65% of respondents used voice trading at some point. While the frequency with which voice trading was used reduced, it was hardly an insignificant amount of time.

One explanation for this is the COVID pandemic skewing voice trading frequencies. Thanks to traders working from home on less than industry-grade connections, voice-trading became a lifeline. However, Coalition Greenwich’s data doesn’t show a massive drop or spike in electronic trade execution. Voice-based trading has always been present to a significant extent in the FX markets.

Andrew Berry, Executive Managing Director of Money Markets, Emerging Markets, and Foreign Exchange at TP ICAP believes market color is a reason traders love voice. “Traders value the extra colour and insight on the market that voice broking provides. Voice broking is useful in fulfilling the best execution requirement, particularly for complex trades.”

While the spot markets have embraced electronic trading, swaps and forwards remain a challenge. It’s easy to see why. The complex collateral management requirements and ever-changing deal terms make it hard for traders to rely on electronic platforms. Also, swaps have traditionally been an administration trade.

Dodd-Frank regulations caused institutions to hemorrhage cash in other areas of their businesses, and the swaps market was left unattended. The result is that voice-based execution remained firmly in place while technology took over elsewhere.

There’s also a belief amongst traders that voice-based execution guarantees better prices. Given the inefficiencies present in current multi-dealer platforms (MDPs), it’s easy to see why this view pervades the market. MDPs deliver price transparency but do not distinguish between an LP and other participants intermediating liquidity. Thus, there’s limited knowledge of where liquidity is present at a point in time.

As a result, iceberg orders and bilateral trades make more sense and this gives rise to voice-based execution. From the buy-side’s perspective, relationships matter when determining market color. Naturally, this leads to a lack of trust in black box-like electronic trading platforms, especially when executing complex trades.

Lastly, inertia plays a major role in the persisting use of voice in trade execution. Traders have been doing it for so long that there’s no incentive to change a system that isn’t broken. However, electronification is steadily creeping into traditionally voice-based markets due to many reasons.

Electronification is progressing

The 2019 BIS Tri-Annual survey found that electronification progressed rapidly in dealer to customer segments, with close to 62% of orders executed electronically. One reason for this is the changing nature of market participants. Thanks to hedge funds and PTFs increasingly entering the market, innovation has accelerated.

Bruel notes, “Principles of best execution are penetrating FX and we’re seeing the buy side increase their scrutiny of FX transaction pricing. The entire FX workflow is ripe for further electronification and automation.” Thus, while voice trading persists, electronic execution and automation is rising. Bruel believes that, “other pre-trade and post trade processes, such as regulatory reporting and compliance” will also undergo electronification as a result.

“We also see that the broader adoption of algos continued during the pandemic, and that growth will persist…”

Stephen Bruel

The dealer to customer segment has historically witnessed the fastest technological innovation. It has the largest number of trading venues and features a diverse range of execution protocols. However, even in this segment, the prevalence of void to execute NDFs holds. Electronic execution accounts for 75% of spot trades, while NDFs and forwards are primarily voice-based.

Berry believes full electronification is an unrealistic target in the NDF market. “There will always be a need for voice broking to deliver complex trades and provide valuable market insight,” he says. “Part of the NDF market is spot and that’s very electronic, but as you move down the curve in terms of time, trades become more technical and a hybrid approach is needed.”

However, recent innovations are changing this picture. BIS noted that 2019 witnessed a rise in electronic NDF delivery for EME currencies. The rise of prime brokers has also pushed hedge funds and PTFs to trade electronically. Electronic solutions are also making their presence felt across all areas of trading operations beyond execution. In the swaps market, for instance, electronic solutions are being used to handle complex credit and collateral management workflows. Simultaneously, the cost of trading seats is coming under increasing scrutiny at banks and has pushed traders to adopt cost-effective electronic solutions.
For instance, electronic solutions currently available in the market automate grey-book mid-market risk exchange in the swaps market. An electronic process brings greater efficiency compared to manual ones during price discovery and credit checks. Vendors have been quick to highlight these advantages, and firms are beginning to take notice.

Regulation is playing an important role in pushing electronification further. While Dodd-Frank unleashed a wave of rules that banks had to comply with, newer regulations such as UMR have left firms with no option but to electronify their processes.

Coalition Greenwich’s FX COVID flash study revealed that 22% of respondents felt COVID had motivated them to improve their operational workflow. Add to this the need to manage risk, cash management, and other aspects of a trade, and it’s easy to see why electronification offers a logical solution.

Roadblocks to change

Despite the proliferation of electronic solutions, voice-based trading is unlikely to quietly fade into the night. Voice-based brokers have been adept at selling their services and have entrenched positions in the market. Most brokers have adopted a hybrid electronic and voice model as a result, and this only maintains the status quo.

Berry explains the reasons for this. “Brokers today can see the value in a hybrid model and view it as an asset,” he explains. “They still have an important role within that, but they can see that electronification brings greater efficiency and transparency for them and their clients.” A broker’s role also plays a part in adopting a hybrid structure. “The role of a broker is to not only match and execute trades,” explains Berry, “but also to provide market context, understand the needs of their clients, and ensure that they meet their regulatory requirements.”

Credit approvals in the swaps market are perhaps the biggest roadblock electronic providers have to overcome. Coupled with inertia are manually intensive processes that don’t lend themselves well to electronification. Many collateral and credit-related decisions need subjectivity, and this makes coding a challenge. 

There’s also the question of trusting third parties with credit-related information. While connecting an institution’s proprietary credit engine to an electronic solution is simple, decades of business practices dictate that outsourcing data like this might lead to information leakage in a notoriously competitive market. For now, a mix of electronification and manual approvals exist in this world.

Electronification costs are also a significant barrier for smaller firms to overcome. Larger firms keen on placing data in-house can afford to build infrastructure and install resources to maintain it. Typically, this involves developing an IT competency that rivals a technology firm. Smaller firms cannot afford to divert resources away from their primary business like this.

Cloud-based products offer a great solution to this problem, but trust is once again the issue. Service providers face an uphill task convincing institutions that their data is always secure and only designated parties have visibility into proprietary processes.

Despite significant investment by larger institutions, a lack of sophisticated infrastructure is preventing greater electronic adoption. Installing IT infrastructure isn’t a one-time job. It requires constant upgrades and patches to keep pace with broader market changes. Companies built with technology in mind from the ground up will understandably do a better job of executing these tasks compared to a financial institution.

Proof of this phenomenon comes from a BIS working paper that highlighted that G-SIB regulations were prompting big banks to pull out of the credit and swap markets at month and quarter-end. Portfolio efficiency is the goal behind these moves, but a lack of insight into portfolio optimization (fueled by a lack of infrastructure) is prompting such moves.

Greenwich’s Bruel believes that the perception of FX trades as not being “alpha generating” is also a stumbling block. However, he notes, “Both asset managers and corporates are increasing their level of sophistication in FX execution and will adopt more electronic tools. The fragmented nature of the FX is also a significant motivator to adopting electronic tools that can help manage that fragmentation.”

All of these factors contribute to greater trust in voice trading. In the face of these challenges, it seems easier to pick up the phone and deal with a person instead of a black box. However, broad changes are occurring that are affecting this picture.

Drivers of change

Regulation in the form of UMR has been one of the biggest drivers of electronification. One of the most resource-intensive parts of the new process, as stipulated, is the initial margin (IM) calculation. Firms are choosing to follow ISDA’s SIMM model for price calculation and adjust their calculations for sensitivity as defined by the model.

This step requires significant data crunching, and a manual process can’t cope with the load. Collateral transfer is also proving to be an issue. Institutions affected by UMR will have to transfer securities to custodians, and this opens a new set of issues. How will these securities be valued, and which models do firms rely on?

Electronification is the easiest and most cost-effective solution to these issues. Coalition Greenwich points out that as algo adoption increases, an increased desire to electronify every part of trade operations and execution is a natural side effect. For instance, PB clients have increased their pace and frequency of trading following electronification, and this has had a knock-on effect on credit and collateral management workflows. Electronification has become a necessity to keep pace with these changes, no matter how complex the trade might be.

Can voice keep pace ?

As the FX markets become more fragmented and complex, it’s debatable whether voice-based trades can keep pace with them. For now, brokers are pushing a hybrid model while encouraging clients to electronify their processes. Berry believes that hybrid broking is here to stay. “There will be more electronification in the market in the future as innovation continues but there will remain an important role for voice,” he says.

Bruel believes electronification still has room to expand and it’s a matter of time before FX is fully electronic. “Voice trading will persist in FX but we have not reached the electronification ceiling. The rate of electronification in FX will depend on the asset class – G10 FX Spot is ripe for more rapid electronic execution whereas NDFs will take more time.”

Traders still value the extra colour and insight on the market that voice broking provides