Taking a closer look at Segregated Execution

In recent years it has become increasingly important for banks to safeguard their client’s trading information using segregated execution desks. This is becoming a best-practice model as it provides a way to reduce potential or perceived conflicts of interest within FX trading businesses.  Having run a segregated execution desk, and spoken to traders on other segregated desks, I find there are usually differences in how procedures and policies are implemented. This article will explore some of these.  In order to do this, we loosely refer to an FX segregated execution desk as a trading desk which manages execution of FX orders without information slippage or taking principal positions. Information slippage, in this context, is where internal or external traders become aware of an order without being a counterparty to it.

Taking a closer look at Segregated Execution
Cameron Mouat cameron@aorakiadvisors.com

Why are segregated execution desks needed? 

Although segregated execution desks are not new in FX, we have recently seen more formalised segregation pressure in response to changes in how banks manage fixing and/or algo orders.  This has resulted in segregated execution desks interacting with clients more like an agency execution desk in futures or equities, enabling them to provide market colour as well as discussing different execution scenarios with clients. There is a natural similarity between the handling of algo orders and fixing orders, as both order types require automated processes to handle flow effectively and have a need for segregation of information.  From a bank perspective, firstly acknowledging and then putting processes in place so that trade or order information is accessible only on a need-to-know basis, reduces risks for both the client and broker.  Principal traders are protected as they cannot obtain order information and the risk of accidental conflicts is significantly reduced.

Setting up a segregated execution desk requires additional resourcing of personnel and technology.
Setting up a segregated execution desk requires additional resourcing of personnel and technology.

For algo orders, the purpose of many executions is to work large interest into the market with “minimal” impact and signalling risk.  This usually involves executing over a longer time frame and means any information slippage about the order could be detrimental to the execution.   For example, prices could be skewed or hedging behaviour changed.  Additionally, once an order has completed there may be similar follow-up orders, so ensuring information is segregated post-trade reduces any potential impact on these.   Even a simple post-trade operation could change the internal visibility of an order in front office systems.

Fixing orders are the reason many segregated execution desks exist.  The information that these, potentially market moving orders contain, provide trading opportunities for market participants.  It is therefore worthwhile understanding how large fixing orders are managed from an information and risk perspective.  A bank may manage fixing orders by initially netting with other client orders, followed by matching against offsetting fixing interest from other banks (through brokers or electronically). Then any residual risk could be traded via an algo around the fixing window.  This order information needs to be kept segregated from principal desks to reduce any accidental or real conflicts of interest.   For example, a principal desk, by coincidence, might be in a similar trading position as the residual fixing risk and trading in the same direction at the same time.

Some banks, however, might prefer to pass the fixing residual directly to another bank to manage.   In this scenario, even if a client gives a fixing order to a bank who has robust information segregation, there is a chance that important order information might be forwarded to another bank, with lesser information controls.  It is therefore important to understand how your fixing risk is handled as each bank will have different policies, procedures and segregation models.

Segregating trade information for small firms

Setting up a segregated execution desk requires additional resourcing of personnel and technology.  This means that for FX firms with smaller fixing and algo businesses, the setup and running costs can be prohibitive, although some measures can be taken to achieve at least part segregation.  At a minimum these businesses should ensure that trading books and order information flow are segregated.  An additional step could be designating an employee to have sole access to the segregated order flow from a physically segregated desk.  Being open and transparent about these policies is likely to be appreciated by clients.    

Conclusion

Although we have mainly focussed on information controls, a segregated execution desk may also provide advisory service for the buy-side.  This could be market colour or different options for executing an order to meet a client’s benchmarks.  However, with the increase in more advanced execution requirements coming from the buy-side, banks need to consider that controlling the flow of client order information could soon become a differentiator.

What to expect from a segregated execution desk?

From a buy-side perspective, ensuring any information slippage is reduced and understanding details about what is being segregated is important due diligence. Below are some points to be considered when talking about segregated execution:

Who is able to view orders/trades before, during and after the execution?  

A segregated execution desk should restrict and have well defined access policies detailing who can view orders/trades in systems from order management, monitoring and booking.  

If post trade operations are performed, does that change who can see details of the order?   

Post-trade operations such as allocations or rolling to outright dates may change the visibility of your order.    

Are there any differences in how information for fixing orders and algo orders are handled?

Algo orders and fixing orders might follow separate workflows so highlighting significant differences is worthwhile.   

Are fixing and algo trading books segregated from other desks?

Trading books should be segregated with restrictions applying to access via UI and API.    

Is information from segregated trades used as part of quantitative flow analysis for other parts of the FX business?

Quantitative analysis of flow is useful market colour for traders and sales.  However, some segregated desks may choose to have their clients flow excluded from these reports.

Is the segregated execution desk sufficiently physically segregated from other trading and sales desks?

Physical segregation is best practice as otherwise there is a chance that information can be overheard when a desk discusses an order.

What are the exceptions to the standard desk processes?

There may be process exceptions such as regional, holiday, or order size variations.

Is fixing residual interest passed to other banks to manage?  

Passing fixing residual interest to another bank to manage may increase information slippage if that bank has weak information segregation processes.

Are segregated policies formalised in trading disclosures?

Some banks may not formalise how they handle trade information in their disclosures which highlights the need to ask questions about their policies.