If history proves anything, it’s that algorithmic trading adoption is going to move rapidly, and so too will execution quality, said Jacob Loveless, CEO of Lucera: “I definitely think you are going to start to see it this year, en masse, at scale and adding value.”
One of the major drivers is that clients don’t want to leave a ‘big footprint’ in the market. In other words, large orders are just not safe: single bank transactions can result in poor pricing and ultimately strain relationships with liquidity providers.
“That is part of the reason why a lot of people are focused on algos. It gives people a good way of accessing the market and spreading out the risk over a longer period of time, and participate in potential positive moves as well as negative moves,” said Soren Haagensen, Managing Director at Integral Development, currently the only provider of end-to-end electronic FX trading platforms.
Bank algos were never an active part of trading desk use…
Typical streaming algos, he added, which hit every single venue at the same time hoping to get executed, on the other hand, do leave a market impact. But most people don’t like to use them because it makes it tougher and tougher to execute your business.
“You might win on the first one but you lose on the other ones,” said Haagensen. “Most people that have an interest in today’s market, based on the people I’ve spoken to participating in algos, (are interested in executing) quietly as possible and leaving as little impact so that nobody knows what you did.”
Getting to the FX Desk
James Dalton, Global Head of Algorithmic Execution at CitiFX, said that the increased take-up he’s seen has been correlated with smaller ticket sizes.
“The vast portion of the customer base would only deploy algorithms across more strategic or sensitive flow – a larger order. The order sizes that are being routed to us and away from risk desks are dropping, and the proportion of investor client order flow being executed algorithmically, if you look at the whole customer base, it’s increasing, steadily,” he said.
Agency-style models will push towards algos…
For most large asset managers, any discussion of algos generally means what’s on offer at the banks. And the adoption of bank algo suites is the bulk of activity that Portware has seen with its buy side clients.
“Bank algos were never an active part of trading desk use, it’s only in the last two or three years that you actually hear them being employed as part of a real strategy,” said Chris Matsko, Head of FX Trading Services at Portware FX, a trading platform.
Some clients, however, are interested in going further in order to avoid divulging an interest to a large block order to a single bank. Instead, they’re looking to parse out the large block trade to either multiple bank algos, or custom designed algos.
FX Execution Bleeding Edge
Executing for a group of portfolios without going to a single bank is a major challenge to the institutional buy side. That’s because across some 1000+ portfolios, there’s directed relationships that mandate which banks can and cannot be traded with.
“In terms of trends, seeing more adoption of the bank algos – yes. But also building internal ECN (electronic communication network) order books based on directed LP relationships, such that traders can avoid a bank algo to hit their own streaming relationships and fill orders in interesting ways that they see fit,” said Matsko.
Those complexities have to be taken into consideration for algo execution, he explained. The “tricky part” is making sure that allocations are filled appropriately, populated back to an OMS appropriately, and that the back office can confirm all the deals.
“It’s more bleeding edge than it’s common place, but it’s starting to creep into the more progressive large tier 1 shops,” he said. “A lot of them are saying: how do I do that and how do I manage that through my current complex state of affairs as a multi-allocation buy side trading shop that’s not prime-brokered?”
Principal v Agency in FX
Over the past few years, banks have been steadily investing in single bank platforms for clients to execute electronically. That may be primarily a principal-based business for now, but there’s a growing important of agency for the future of banks operating in the FX market, said Sang Lee, Managing Partner at Aite Group, a consultancy.
Banks have less incentive to take risk and provide principal-based business
Historically, the global FX market has been principal-based, meaning banks are providing the liquidity, while clients looking for liquidity trade against the banks. Banks stump up their own capital and hedge risks in the interbank market.
Electronic trading strategies saw banks starting off with single stream algorithms as a client service to trade more efficiently on their bespoke platform and capture flow. Agency-driven business, however, negotiates a multi-bank, multi-stream algorithm environment nowadays, with a multitude of routing venues.
All signs point to the adoption of a kind of hybrid model, explained Lee.
“A lot more banks are talking about whether or not it would be wise for them to spend more time adopting their agency business on the FX side,” he said. “Instead of making money off the spread, it would essentially be on a commission.”
There is sometimes a grey area between principal and agency models, said Victor Lebreton, Director at Quant Hedge, a medium and short term systematic trading firm in FX markets.
“Most probably, when investment banks say they are 100% principal on the markets , you can understand that maybe 10%, or 5% is agency brokerage service for privileged institutions, where they try to get better prices for their client and themselves,” he said.
How adoption of a hybrid model might unfold under regulatory scrutiny remains in question, since it gives rise to perhaps the greatest potential for confusion, and banks and clients are anticipating clarification on what is and is not allowed, reported Euromoney.
Even so, while banks like JP Morgan, Deutsche Bank, Barclays, among other ‘usual suspects’ are asking how to compete in a more agency-driven business market environment, said Aite’s Lee, FX algos all of a sudden look very important.
(People) need to start tackling the problem of figuring out where to route orders…
Agency Business Needs Algos
The competitive push is what drove banks to develop algos in the first place, but until very recently, uptake has been disappointing. Over the last couple of years, gaining a competitive edge is necessarily being considered in tandem with major regulations coming down the wire for banks, in particular capital and liquidity requirements in the US and Europe.
“Banks have less incentive to take risk and provide principal-based business…that’s definitely driving the thinking process, even within the FX market,” Lee said.
This, despite the realities of a relationship-driven, decentralized market structure with no real benchmarks. And there’s still plenty of phone calls being made for sizeable positions.
Lucera’s Loveless said that the principal business is here to stay, it’s just not going to stay over the phone. But in a wildly fragmented market, aggregation is going to be sought after too.
“Agency-style models will push towards algos, because what does an agent provide? They are not principal to a trade, they are not providing liquidity, they are generally not providing credit, their value-add is really providing execution quality,” said Loveless.
“They’re going to push it in a different way than a principal model, but the end result is going to be the same – better executions will follow,” he said.
Lucera runs the largest SDN (software-defined network) in financial services across 53 data centres in 24 countries, with foreign exchange activity a big part of the network. Last year, it was all about connecting to multiple venues. This year, it’s all about where to route the order.
“(People) need to start tackling the problem of figuring out where to route orders, and that’s one of the big reasons why you’re seeing the rise of algorithms and that’s why we saw it in equities as well,” Loveless said.