All Together Now?
publication date: Feb 4, 2008
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author/source: Frances Maguire (February 2008)
The race is on to build and provide a single, virtual ‘aggregated’ view of the market. Only then, reports Frances Maguire, can algorithms really succeed in searching pools of liquidity for the best price.
Securities and investment management industry experts, the TABB Group, estimates that electronic trading in FX reached 62% of daily trading volume at the end of 2006, and will easily approach 80% by 2010. This surge, coupled with the growing number of new participants, means that FX is fast becoming a volume-game and being able to deal in large sizes is very much down to the technology used.
Laurie Berke, senior consultant, at TABB Group, says: “Along with this increase in electronic FX trading comes an increase in the use of algorithms in FX. In particular, the dealers have had to implement a high degree of algorithmic capability to handle the rapid increase in inbound electronic order flow from clients. We estimate that the major dealer banks are using streaming pricing and risk management algorithms to handle upwards of 75% of their daily flow.”
Laurie adds that the hedge funds, which are actively trading FX as an asset class, are also amongst the larger users of algorithms in FX. They are receiving dealer prices electronically across multi-dealer platforms as well as tapping into the liquidity available on alternative venues such as Lava, FXall and Hotspot, and are using algorithms as much as two thirds of their trading, in the main, highly-liquid, currencies.
“I would estimate that the percentage of that volume being executed electronically as of year-end 2007 has grown to at least 68%, accelerating even more quickly than we might have expected even 6 months ago,” she says.
Although traditional buy-side institutions and asset management firms are beginning to implement the technology to enable them to manage and transact in FX markets in-house from their own trading desks, the adoption of algorithms is still at an early stage, with less than 10% of their FX trades executed using rules-based trading tools, according to TABB Group.
However, this looks set to change, but because the FX market is fragmented across different trading portals, ECNs and dark pools of liquidity on banks’ books, algorithms cannot work successfully in finding the best price until these sources are aggregated. Additionally, many of the order management systems used by asset managers were developed before the concept of algorithmic trading existed and cannot readily be adapted to incorporate algorithms and for algorithms to be truly effective, aggregation is needed.
Mike Thrower, head of sales and marketing at Cognotec, says that many of Cognotec’s clients, which tend to be tier 1 and tier 2 financial institutions, now have very complex FX distribution environments and this can mean providing liquidity and pricing to futures exchanges, ECNs, portals, white-label partners as well as all the other parts of its own franchise. “The FX desk, which historically might have been a pure institutional and corporate client service, has been a much more fragmented and more complex environment needing sophisticated technology,” he says.
According to a recent white paper published by Cognotec, FX: in a class of its own, many providers often have to support in excess of 20 separate eFX channels so that the low latency of the FX market is under threat from increased volumes, as more investors trade from an increasing number of venues. The white paper also reveals that despite the fact of most algorithmic trading activities being simple automated trading strategies, algorithms are starting to put a strain on the current generation of sell-side systems, which were not built for such high volume and high speed trading.
Says Mike Thrower: “Portal aggregation is clearly a massive challenge because it is such a fragmented market. However, with algorithmic technology being used by the sell-side it is becoming much easier to find pools of liquidity and prices, adjust their prices accordingly.”
Algorithms allow both the buy-side and the sell-side to quickly analyse and compare prices, and investment in rate technology then enables the sell-side to price and distribute what has come in, and take a view. According to Thrower, there is still opportunity for price arbitrage, despite heavy investment in rate management technology, because not everyone is at the same stage as the top five banks, but increasingly the technology developed by the tier-one banks is being white-labelled and more widely distributed.
As Mike Thrower comments: “There is a real challenge for all participants as volumes increase, margins get ever tighter, and FX becomes a commoditised flow game.” He adds that the buy-side firms are increasingly becoming price-makers and a lot of medium-sized banks are looking to outsource their liquidity to the tier one banks and become distributors of liquidity, rather than manufacturers.
Dr John Bates, founder and vice president, Apama Products, Progress Software, believes that aggregation of the market is the fastest growing trend in FX. “As the number of FX trading venues continues to grow, a real-time single view of the market and available liquidity becomes more in demand. Additionally, real-time risk management is now a basic essential, to enable checks of compliance rules and enable continuous VAR re-calculation to see if any key thresholds have been breached.”
According to Dr. Bates there are fewer straight arbitrage opportunities now and it takes complex maths and statistics to find the more obscure arbitrage opportunities. There are some time-lag advantages to be taken but the latency is being squeezed out of the connections, so that more and more of Apama’s customers are connecting directly to these pools, rather than going through intermediaries, and building faster connections and optimum hosting environments.
Banks need to be prepared and should not use protectionist policies if they want to offer liquidity. Banks are increasingly realising they have to embrace algorithmic trading and FX algorithmic trading is evolving rapidly.
In his opinion, Dr Mark D. Spiteri, Director of Software Development, Apama Products, Progress Software, says that Apama has been offering connectivity to about seven FX venues and that aggregation and smart order routing is completely customer-driven. There is a very strong demand. As he explains: “Smart order routing is the other side of the same coin – aggregation creates the virtual ‘superbook’ but the next stop is to ensure you are placing those orders in the best possible venue in terms of price, brokerage fees, and latency.”
Rick Schumacher, head of products at provider of treasury, trading and settlement solutions, Wall Street Systems, says there has always been an argument that an exchange-model would make this a lot easier but if the FX market ever does get there, it will be very far down the road. “There are so many reasons why an exchange for the 24/7 FX market is not going to happen. There will, however, be continued consolidation amongst platforms, particularly if you question the number of technology projects that will be deferred in 2008,” he says.
According to Schumacher aggregation will come from a variety of fronts. He says: “The continued emphasis on platform connectivity will be extended with banks and asset managers aggregating requests from their counterparties to consolidate their activities; aggregation will also start in post-trade processing, in terms of pre-settlement netting. Aggregation is hitting the entire STP process from price discovery right through to settlement as firms trying to find ways to push through greater volumes.”
He says that Wall Street Systems is increasingly being asked to build rules and techniques to enable a customer to determine where it executes transactions and which liquidity provider it uses, based on a workflow engine to aggregate orders coming in from clients and build smart workflows around execution venues for allocation. Additionally he says that Wallstreet is starting to see requests for rate blending engines, which can aggregate prices from multiple channels and push that out to customers, with a spread based upon the distribution platform used.
Schumacher believes the consolidation will come mainly amongst the platforms as the banks will always service their constituents, and the tier 2 and 3 banks are still seeing growth in FX. “They are not market makers but their client business is sizable. More of these banks will decide to take a stream from one bigger player, and take a spread on that, so this will lead to greater consolidation,” he says. This will enable these banks to still offer customers value, and lower their costs. They may continue to make selective markets to their customers though, primarily in local and regional currencies.
Mark Akass, CTO, BT Global Financial Services, believes the long-term impact of algorithms on FX execution will be profound. Akass asserts that algorithmic FX execution has had the knock-on effect of altering the balance of power between the bank and its own clients.
Traditionally, banks have held control over the price and spreads within FX, but it now appears that power is progressively being lessened,” he says, adding that “algorithmic trading enables the buyer and seller to gain competitive advantage by timing their entry and exit into the market. They are now able to make price on a large amount in the same way as a bank, which means some are finding themselves well placed to act as the aggressor in the market, or even as a market maker.”
The challenge is accurately achieving this single view of the market through aggregation, using APIs, to enable algorithms to analyse liquidity and route orders to the best price. The race has already begun; it is just down to how fast the industry can run.
