“Algos for forwards would allow us to execute in a more automated, rule-based fashion with straight-through processing, which meets regulatory and client wishes more than the current situation.”
Ceding control of the execution of a trade to an algorithm developed by a bank or technology provider is a leap of faith for any buy-side firm, so it is only natural that such practices should start off in the simplest and most liquid markets. In foreign exchange, that means spot, where just over $2 trillion is traded daily, according to the Bank for International Settlements’ (BIS) last triennial turnover survey in 2013.
But as the popularity of algos in spot FX continues to grow, users are impatient to see tools developed for other FX products, particularly forwards, given their importance as a hedging and investment tool. Some algo providers already offer FX forward functionality, often as an extension to spot algorithms, but their use has not yet become mainstream.
“More than 90% of our FX business has a forward leg to it, so we would be very interested in a solution for FX forwards but we haven’t been offered a demo of anything yet.One problem is that we would need an ISDA Master Agreement and Credit Support Annex to support a forward, so we would probably need to use a bank with whom we already have that documentation in place,” says Lee Sanders, head of FX and money markets execution and UK and Asia fixed income trading at AXA Investment Managers.
Other buy-side algo users echo Sanders’ call for more attention to be focused on forwards.
“More than 90% of our FX business has a forward leg to it, so we would be very interested in a solution for FX forwards…”
Patrick Fleur, head of trading and execution at Dutch pension fund PGGM, has seen very limited appetite to branch out into forwards among his firm’s counterparties, despite widespread demand.
“Algos for forwards would allow us to execute in a more automated, rule-based fashion with straight-through processing, which meets regulatory and client wishes more than the current situation. We’d want to start with simple limit order types and then move onto more sophisticated algos like time-slicing, once there is more data available,” Fleur explains.
“So far, however, this seems to be a bridge too far,” he says. “There is no real electronic market for forwards, so old-fashioned risk warehousing is still the main execution channel. It’s an area we would very much like to see the big liquidity providers focusing on, but it’s not a topic that is gaining much momentum.”
Providers are listening
Demand for forward algos is not falling on wholly deaf ears, however. JP Morgan recently launched additional functionality that allows users of its spot algos to pre-set a forward date and then have the algo automatically roll forward after it has executed. Currently available only through its single-bank platform, the spot contingent forward order will be extended to multi-bank portals in the coming months.
But making non-spot algos available through multi-bank channels may be a challenge for providers, as some platforms have not yet developed their interfaces to be able to handle algorithmic execution of swaps and forwards. TD Securities, which has offered its clients the ability to specify a future value date since the inception of its algorithmic offering several years ago, has encountered hurdles in the structure of the FX market.
“Not all platforms are yet capable of handling the FIX messages that go with algorithmic execution for forwards and swaps, which means banks can’t always offer algos through those channels. Bloomberg and FX Connect do offer TD’s forward algo execution abilities, so the capability is out there, it’s just not widespread. Swaps are particularly challenging because they have two legs, which adds complexity for distributors,” says Paul Aston, head of quantitative and algorithmic solutions for institutional FX at TD Securities.
But these are barriers that must be overcome, Aston believes. The BIS 2013 survey reported average daily turnover in FX forwards to be $680 billion, while FX swaps had reached $2.2 trillion, just surpassing volume in the spot market. Volume in FX forwards grew by 43% between 2010 and 2013, while during the same period the swap market grew by 27%.
“..it’s something of a surprise that most algos only offer execution in the spot market, since many client transactions really need to be executed as forward transactions.”
“Foreign exchange is an OTC market based on lines of credit where most transactions are traded to value dates other than the spot date. So it’s something of a surprise that most algos only offer execution in the spot market, since many client transactions really need to be executed as forward transactions. This is most likely due to the fact that most algos in FX were originally developed for equities trading and not FX. When we developed our algo platform, we wanted to ensure that clients could trade FX exactly the way currencies are transacted and exactly in line with their needs in both the spot and forward market,” says Aston.
Other banks may not yet have developed algorithmic tools outside the spot market, but some are considering doing so. “There is definitely significant demand for forward algos and we have it on our development list. The challenge is that the forwards market is still largely a voice-driven broker market, with very little volume traded purely electronically. Forwards will evolve in the same way the spot market did, but there is still some way to go,” says Pete Eggleston, head of quantitative solutions and innovations at Morgan Stanley.
“The challenge is that the forwards market is still largely a voice-driven broker market, with very little volume traded purely electronically.”
“Demand for non-spot algos is driven mainly by the need for efficiency,” he adds. “The buy side is also under enormous resource constraints and they need to make the trading desk as efficient as possible so that they can really focus on the value-added aspects of their role. Expanding the use of algorithmic tools to automate and simplify workflows is one way to help achieve that.”
TD Securities, JP Morgan and Morgan Stanley may not be the only banks offering FX forward algos, or planning to do so, but some buy-side firms would like to see more sophisticated tools developed, rather than simply having roll functionality added onto existing spot execution tools.
“Rolling a spot trade forward algorithmically is a useful workflow tool but it doesn’t necessarily create the best liquidity. We’d like to see algos with more flexibility and centralised forwards liquidity,” says Sanders of AXA Investment Managers.
Some observers believe it is the lack of centralised liquidity, and the fact that much of the forwards market is still voice brokered, that is constraining the development of algos. If a greater proportion of the market were to be executed electronically, that might pave the way toward the development of more sophisticated algo tools.
“There is some appetite for algos in swaps and forwards, but we’re not there yet in terms of having a central liquidity pool where you can buy and sell at tight spreads, as is the case in spot. It will initially be trialled in the most liquid pairs and the most standardised contracts, but algo execution in non-spot FX is still very small at the moment,” says Javier Paz, senior analyst at Aite Group.