Colin Lambert talks to Allan Guild, global head of alternative execution services, FX and commodities, at HSBC, about the next evolution of the algo execution world.
Colin Lambert: What does Alternative Execution Services do?
Allan Guild: The Alternative Execution Services (AES) Team is part of HSBC’s global FX business. It makes FX execution algorithms available for client use and manages the resulting orders and execution globally within the bank’s Global Markets division. AES is segregated from the GFX e-risk, sales and market-making activities. In addition to providing execution algorithms for client use, AES also provides alternative FX execution solutions.
CL: We hear of increased algo usage by clients and it certainly seems to have grown as a product set in the past year, assuming that, how are your clients deploying your algo suite?
AG: The key thing that keeps coming up in our conversations with clients is how their own stakeholders and investors are focusing more on their FX execution. There is generally greater regulatory focus from the buy-side and particularly amongst asset managers in the post MiFID II world. A key element in those conversations with buy-side in particular is that they want to better understand and therefore control their own FX execution. In these circumstances, when we’re having those conversations with our clients, it’s really about understanding the client’s execution objective. It often boils down to clients looking to use our execution algorithms to do one of three things.
Firstly, they have a defined period of time over which they want to execute and they want to schedule execution over that timeframe relatively evenly. Alternatively, they effectively want the algo equivalent of an ‘at best’ order – and what I mean by that is they have an FX order and it is going to be judged based on the difference between the price at which they execute and the arrival price when they received the order. The third camp is clients such as very large multinational corporates who, due to the shape of their business, are always going to be one way in the market in a particular currency. Their ambition is to execute their hedge with as little market impact as possible – they want to execute without the market deviating from the path it was taking, they understand that their hedge is going to be executed based upon market conditions and less upon timing or arrival price.
So it’s a big driver for us to help ensure our clients are empowered to own their FX execution risk and that they understand their own execution objective – and pick the right algo strategy to meet that. Therefore, it’s important to offer an algo suite that is as simple and as easy as possible to use – the client works out their objective, picks the corresponding algo strategy, puts in a well-defined set of parameters and it’s then that the complex piece takes over, and that’s what effectively a client is paying a fee for – how actually the parent order is going to be sliced up and the execution outcome for each child order. In this way, we have optimised execution as a whole, in order to better meet the client’s objective.
Our execution services business also uses the same e-FX infrastructure and algo strategies that our principal business uses. When the principal business is managing its risk, it has the same three objectives that we mentioned before as our algo clients. So every time we optimise and improve our algos to benefit the principal business, these improvements also benefit those clients using our algos. Although both businesses use the same algo strategies, the client algo business is entirely segregated from principal trading.
CL: So how is the pre-trade piece evolving? I understand it’s about giving the client the tools to help them make the best possible decision, but we’re getting into tricky territory around advice perhaps?
AG: Because our client algo offering is segregated, we make it clear to clients that not only are they taking execution risk, but also this is an arms-length unadvised relationship. Obviously, we want our clients to have the best possible outcome, but we’ve got to recognise that the framework in this instance is that when clients use execution algos, they are responsible for the execution outcome and we engage with them on a non-advisory basis.
It’s about providing them with available market information and making sure that we’re empowering them to make the most appropriate execution decision for their own risk management purposes. It can be complex because we serve a huge range of FX clients – from some of the most sophisticated participants in the market to clients for whom FX is something that they have to do and which they haven’t been particularly focused upon. So it’s important to understand the best way to engage with the client and ensure that they understand what it means to run an algo.
CL: So education is a big piece of what you’re doing.
AG: Absolutely – and that includes understanding when it may not be in the client’s interest to use an algo. People have been saying for years that FX is going to be like equities and that some 80% of FX execution will be via algos, but that is unlikely to happen due to the effectiveness of risk transfer through market-making in spot FX. There are different ways of efficiently transferring risk from someone who has that risk, and wants to hedge it, to someone who wants to make a market for it – algos are just one mechanism. As a principal market maker, it is not the intention to take execution activity from clients who are using spot market-making to hedge their risk, which works well for them, and moving that flow to algos.
Algos may, however, be a better risk tool for more sophisticated clients who are significant participants in the FX market with a lot of risk to cover on a regular basis and who want to manage their own execution. Our analysis shows that over time, on average, these clients will get a better execution outcome by using algos and that’s why we’ve seen an increased pickup in the product. But the idea that algos are for everyone and that everyone is going to use them really misses some of the points of difference between FX and other markets.
CL: As more clients use algos then, what about the control functions? It seems to me there are potential reputational risks around how those algos are used.
AG: I’ve been very much involved in the development of the FX Global Code, both in terms of HSBC’s internal implementation and external discussions; the issues covered in the Code are very relevant to the algo business. Ultimately, it’s about partnership. We have to establish a clear framework in which we, as the business, own the operational risk and can manage that effectively. We have in-house compliance officers who advise on what we have to do to ensure our algo business is appropriately managed and that we meet our regulatory obligations.
So it’s about partnership and thinking about what is the right outcome for the client and for HSBC, and I’ve yet to really see a situation where those two things diverge – and about thinking it through and making sure you’re leveraging, in a positive and constructive way, the expertise and advice that a strong compliance function provides.
CL: Can you talk a bit more about that? There are concerns in the industry that even if it is inadvertent, if a client using your algo triggers a flash event, there will be fall out – what kind of protections do you put in place?
AG: There are two elements to this – the quantitative and the qualitative. The quantitative element is the design of the algo trading platform, incorporating circuit breakers, stop-out thresholds, the maximum amount of currency that a client is comfortable with executing over any time period, and so forth. Built into our algos, for example, are a number of automatic circuit breakers that help preserve market integrity.
“It’s important to offer an algo suite that is as simple and as easy as possible to use – the client works out their objective, picks the corresponding algo strategy, puts in a well-defined set of parameters and it’s then that the complex piece takes over, and that’s what effectively a client is paying a fee for”
How our algos work is also explained at the outset to our clients. The client puts the strategy on – and the qualitative element is when we monitor each algo execution with checks that are running continuously. That is an intrinsic part of our service to clients, making sure they understand our offering and being there to help while their algo is running.
The algo also has a speed dial to offer a little bit more control for the client, and we will say if you speed it up, this is what we estimate the outcome will be, and likewise if you slow it down.
CL: Do you establish limits on speed as well, especially in terms of going too fast?
AG: Yes, absolutely we do but it’s not only about going too fast; it’s also about an algo executing too slowly if a client is targeting an arrival price using the algo. With an implementation shortfall strategy you’re targeting an arrival price and there’s only so much volatility risk that you want to take. That’s part of explaining the strategy and having that conversation with each client and, to your point on going too fast, yes, we do monitor activity closely and we are very aware of the market impact of possible flash crash events on clients.
In such a scenario of a disrupted market, there is the manual ‘kill switch’ on the algo trading platform as a measure of last resort, to maintain our duty of care to clients and our regulatory obligations of helping to maintain an orderly market.
CL: We have mentioned the FX Global Code a few times, is that helping the build out of the algo business?
AG: It’s actually helping the broader FX business and the algos are just part of that. The Global Code has definitely given us a gateway into conversations with our clients that have enabled a deeper partnership across the board. It’s not about us looking to sell a client a product at a price, it’s about us looking to partner with our clients around what services we can offer, and how we can understand the problems that our clients face. But embedded in what you’re saying, Colin, is also about making sure clients understand the challenges on the sell-side as well and that we can have a good two-way dialogue.
For the algos, it is offering an alternative to clients; our Alternative Execution Services business is not about taking over the risk transfer service we offer at all, it is exactly what is says – an alternative service for those clients that want to use algos and who can benefit from partnering with us to optimise how they use them.