A new report from Greenwich Associates sees algorithmic execution becoming “increasingly popular” among FX traders and argues that traders currently not using the strategies, “may soon have to determine whether they’re putting themselves at a disadvantage by not leveraging all the available tools to achieve the best outcomes for their institution and clients.”
The report does observe that many buy side traders remain reluctant to opt for fee-based execution, although it argues that those that have used algos have discovered that their overall execution costs have dropped “meaningfully”.
The survey was taken following interviews with 79 FX traders at hedge funds, asset managers, corporates, and other types of financial institutions in the US and Europe to gather their perspectives on the perceived benefits of using algos to execute FX trades, insights into their decision-making process on selecting an algo provider, if they do not use algos, why, and how they use TCA as part of their investment process for FX.
The research finds that approximately 10% of all dealer-to-client FX volume is executed via algos, significantly less than equities markets where Greenwich says around half of volume uses algos.
In spite of anecdotal experience in the FX industry where some banks have had mixed fortunes at best when rolling out FX specific algos based upon equities models. Greenwich says it anticipates that over the next few years, the market for FX algos will look more and more like equities.
Its rationale is the push from regulators, as well as best-execution committees and policies, meaning traders are going to need to reduce costs while maintaining (or improving) the quality of the execution—two benefits that algo users realise.
“We are starting to see this evolution,” the report states. “Although only 1 in 10 FX traders currently executes with algos, Greenwich Associates research has found that 1 in 4 of the largest institutions use them. When they do, it can be for upward of 25% to 30% of their volume. “
The report expects the percentage of FX volume executed by contingent order to rise from 29% currently to 31% in the next two-to-three years; but it sees more significant growth in fee-based execution, from 20% currently to 27%. It also foresees a rise in benchmark execution from 10% currently to 16%.
Unsurprisingly, the research finds that 84% of buy side traders use an algo supplied by their dealers, while 16% build them in house. In what may be seen as a blow to what was once seen as a growth story, only 5% use third party provided algos.
The report says that traders?are increasing their due diligence when selecting which algos to use. Historically, Greenwich says, the strength of dealers’ marketing efforts were one of the prime determinants of how widely used their algos would be. With the pressure by regulators and investors, combined with the growth in independent data providers such as BestX and ITG, clients are moving more toward a factually based decision-making process.
Unsurprisingly, the quality of execution was the top criteria for 67% of interviewees, while 44% cited either the quality of the consultancy work around the use of algos, or the quality of access to liquidity as their top priority. The transparency of the algo’s logic and operation was top of the list for 39%, while 33% said the anonymity provided by the use of an algo was their top concern. The survey also finds that 22% had ease of customisation as their top priority, while 17% saw it as the answer to their need to connect to different liquidity venues. An indication of the greater understanding of the value of algos comes in the statistic that 57% of interviewees use different strategies for different types of trades.
Greenwich says that over 70% of users conduct some degree of analysis over the quality of liquidity the algo will access, for some it is an informal discussion with the provider, for others it is by means of a thorough testing programme before it is deployed. A change identified in the report is the demand for better analytics around how the algo works and its logic from customers. “As traders are less likely to accept the response of ‘trust us’, dealers are becoming more transparent in the amount of information that they provide to a client selecting an algo,” the report states, adding that it expects to see increased scrutiny of the routing logic and rules surrounding the algos as they are deployed further.
On the question of paying fees, which has traditionally been anathema to buy side FXtraders who are used to paying a spread, the report says that algo users typically see their overall executions decrease meaningfully when using an algo and, therefore, the benefits (in terms of execution cost savings) far outweigh any fees for algo usage.
Although only more sophisticated users tend to want to customise an algo, when they do the report finds that 79% adjust the aggressiveness of the strategy, 47% adjust the trigger level and 32% the order routing and venue selection, while 26% adjust the percentage of volume (participation rate) criteria.
Although it is cited as a customisation 32% adjust the algo by performing the largely administrative task of rolling the completed trade to a forward date.
When asked about the impact of the use of algos on the trading business, 58% say it has led to lower execution costs, while 37% say it has had no impact. 26% say traders have been freed to spend time on other more complex tasks and 11% say it has allowed the firm to reduce the number of traders on the desk.
Inevitably, regulation is cited as a driver of algo uptake, especially MiFID II, and the report says that pressure from investors will push traders to move past using TCA as a simple “box checking” exercise and, instead, view it as a value-adding part of their trading process. “Even though nearly two-thirds of traders use data provided by their dealers to evaluate algo performance, traders are also turning to third parties like BestX for information to assist in this process,” the report states.
“The results of this analysis are not being collected or used in a vacuum, it adds. Despite increasing pressures on firms to prove that they have achieved best execution (and algos are quickly becoming a tool to aid in this), nearly half of FX traders in the study say that using TCA has changed the way they are trading. Increasingly, traders are taking the results from their TCA process not only to prove that they have achieved the best outcome, but also to help inform their decision-making process in the future.”
The report does acknowledge that adoption of algos to date has been “slow”, and it says that one common refrain from non-users was they do not trade frequently enough to justify the investment needed to alter their operational processes in order to support an algo. “However, as with any new technology or tool, more widespread adoption will likely lead to diminished costs,” Greenwich says.
Another concern for traders was uncertainty that using an algo would actually improve their performance. “While this may have been harder to demonstrate a few years ago, Greenwich Associates expects that as more traders use algos and the metrics to measure performance become more sophisticated, it will be harder to make the case that algos do not perform as advertised,” it says. “In fact, one might have a proof case available already: If algorithms don’t improve execution performance, why do many traders use more than a dozen algos?”
In justifying its case that the next two-to-three years will see an uptake in algos, Greenwich says that traders that currently do not use algos should be asking themselves whether they are able to consistently get the best outcome without having that tool in their arsenal? Although it may take some effort to begin using an algo, with all of the data available demonstrating the benefits/cost savings, the ability to execute a trade with an algo will soon become a “need” as opposed to a “nice to have”, the firm states.
Even though change does not come overnight, Greenwich says it believes the current period in the FX markets will been seen as the beginning stages of an evolution. “The algo landscape in FX will increasingly look like equities, where traders see algos as a critical part of their day-to-day execution, “ it concludes.