The foreign exchange market has undergone significant structural changes in recent years. The liquidity structure has changed, since established market participants have less risk-bearing capacity due to regulatory reasons and have to react to the emergence of new market participants. The Dodd Frank Act in the United States and the European MiFID II regulation have also had an impact on the market structure and have forced trading, not least with currency derivatives, onto stock exchanges or electronic platforms, so-called trading venues. As a result, FX trading has become increasingly electronic and automated. In addition, market participants must meet considerably more extensive best execution requirements.
With regard to foreign exchange derivatives, market participants are expected to perform a more intelligent transaction cost analysis, in particular by anticipating pre-trading costs and comparing them with actual post-trading costs. There is also increasing market acceptance of the FX Global Code of Conduct. The current list of 700 signatories to the Code includes the 30 largest banks, EU central banks, selected sovereign wealth funds and supranational corporations. The Code contains 55 principles for best practice in the foreign exchange market, including ethics, transparency, governance, information exchange, electronic trading, algorithmic trading and prime brokerage. It identifies global best practices and processes to help review and develop internal procedures to restore public confidence in the market after numerous foreign exchange scandals. For the first time in years, the financial industry has reached a point where most of the regulatory requirements have been implemented.
Among other things, algorithmic execution and transaction cost analyses offer exciting opportunities to create new added value. Furthermore, the structural market changes lead to an increasing information density among market participants and present them with the challenge of processing the available data volumes and incorporating them into their decision-making processes.
Implications for the trading process
The ability to trade foreign exchange on electronic platforms has been around for over two decades. However, this trend has accelerated since the Lehman crisis and has been exacerbated by regulation in recent years, which demands a higher level of transparency. This development has been supported by advances in processor technology, inexpensive storage space and fast networks that allow data to be exchanged almost in real time.
Whereas 10 years ago most of the daily FX volume was traded by telephone, about 70% of today‘s foreign exchange trading volume is handled electronically. The resulting efficiency gains have also significantly reduced trading costs, measured as bid-ask spreads. At the same time, the increase in electronic trading has led to an elevated use of trading algorithms. On average, this resulted in a rise in individual tickets per order for the same order volume. This higher ticket volume thus entails an expanding need for post-trading automation. Only those who are able to process the majority of all transactions automatically can benefit from the opportunities offered by electronic trading. A further consequence is the generation of an enormous amount of data. These data represent again the basis for a great number of analysis possibilities. An example is the life cycle of an order. From the generation of the order in the pre-trade phase up to the execution phase of the order and finally the so-called post-trade phase, the market participants have almost real-time analysis options at their disposal.
MiFID II requires companies to adopt a systematic approach and monitor all trading transactions
Increased efficiency in the life cycle of a transaction
MiFID II requires investment firms to take all necessary steps to obtain the best possible result for their clients when executing orders, taking into account costs, speed, probability of execution and settlement, size of the order and type of order. The first MiFID regulation required only that asset managers take all reasonable steps to achieve the best result for their clients. In contrast, MiFID II requires companies to adopt a systematic approach and monitor all trading transactions.
7orca‘s aim is not only to meet regulatory requirements, but also to use best execution tools and transaction cost analysis to increase customer value. The execution quality makes a significant contribution to the overall performance of currency overlay strategies. Therefore, the trading process is a major focus for us.
7orca‘s best execution process is based on the life cycle of a transaction and is divided into three phases: pre-trade analysis, trade execution and post-trade analysis. The aim of the pre-trade analysis is to identify the strategy with the lowest transaction costs before the trade is even carried out. 7orca analyses the ideal trading time based on the FX exposure to be hedged and the currency-specific liquidity curves. In addition, the current market depth and volatility determine the execution strategy. In this step, 7orca also determines whether a trade is to be executed directly or in a market-friendly manner using an algorithm. The aim is in particular to minimise the visible and non-visible transaction costs.
7orca‘s best execution process is based on the life cycle of a transaction
When implementing an overlay strategy, various hedging instruments come into consideration. For this reason, a decision must be made in the context of trade execution as to whether the trade is to be implemented using futures or forward transactions. The most competitive price for a futures transaction is already given by trading via the exchange‘s order book. Forward transactions are carried out by 7orca with the largest and most competitive liquidity providers directly connected to the trading systems. 7orca places them in direct competition and is thus in a position to achieve interbank conditions. As part of the trade execution phase, 7orca monitors current market parameters and adapts the execution to changed market conditions. The aim of the post-trade analysis is to monitor transaction costs in particular and, if necessary, to develop enhancements for the future trading process. The experience of 7orca has shown that regular broker communication can further improve prices. For this reason, an ongoing evaluation of the brokers is conducted
Increased efficiency through intelligent order execution
In implementing the system and trading architecture, 7orca places a strong focus on intelligent order execution, straight-through processes and automation. As a result, manual intervention is largely avoided and operational risks due to human error are kept to a minimum.
The processes run without manual intervention, from order generation to checking legal and customer-specific limits, from the transmission of trading transactions to trading venues to order matching and confirmation via SWIFT. In order to reflect the changed liquidity structure as well as to tap a large number of different liquidity providers, 7orca has decided to work with the two leading multilateral trading facilities providers.
The overlay manager thus has access to a range of advanced execution tools to intelligently access various liquidity sources. Especially in the current environment with highly fragmented and sometimes significantly overestimated liquidity these tools offer a wide range of opportunities to improve execution quality.
Particularly in the case of large orders, it is important to keep the visibility in the market as low as possible. These orders are placed and executed successively in the market after being divided into smaller part-orders. The key to success is a sound assessment of the current market situation. If the part-orders are placed too quickly on the market, the trading costs will be potentially too high. If the orders are placed too slowly in the market, the market risk increases as the market movement can be unfavourable.
A final word on algo use
It is important to balance the conflicting priorities of market impact and market risk based on current market parameters. Here, trading algorithms can be used to place small parts of the original order in the market, thus making optimum use of the available liquidity whilst significantly minimising the impact on the market. The decisive factor is the use of the most advanced algorithms to mitigate the signaling risk, i.e. to disclose the trading intention during execution.