Algo Types
Before we investigate the benefits and pitfalls of using algos, a brief overview of the range of algos now available for FX should be helpful. Although there are now well in excess of 100 different FX algos available on the main multidealer platforms, this universe can be simplified into a number of broad categories as illustrated in the diagram overleaf. There are, however, different dimensions to how an algo should be characterised, for example:
• Algo style
• Liquidity source
• Liquidity interaction
So, any given TWAP algo could be very different to another TWAP algo depending on the liquidity sources it has available to it and how it interacts with this liquidity.
Benefits
First we’ll review the potential benefits of including algorithms in your menu of execution options, which are summarised below.
1. Cost reduction
Using an algorithm can result in significant transaction cost savings, although there are a number of caveats here that we’ll cover in the following section on pitfalls. Such savings can result from a couple of sources: i) reduced spread costs as the individual child orders are smaller, and ii) reduced market impact costs.
2. Market impact
Reducing market impact is becoming a higher priority for market participants as the increasing fragmentation of liquidity within the FX market, and associated volatility, is making execution of larger ticket sizes more difficult.
Carving an order into smaller child orders, and distributing carefully via a smart order router, can help reduce market footprint, thereby resulting in improved overall execution.
3. Liquidity sources
The increasing fragmentation of liquidity as new venues are established, and new participants enter the market, is creating a significant overhead for participants who would like to directly access as much liquidity as possible.
The use of certain algos effectively provides this access in a cost effective fashion, as the algo provider is delivering and maintaining all the necessary venue connectivity.
4. Operational efficiency
Algos can be a useful tool to increase efficiencies by effectively outsourcing the management of certain orders, which may be beneficial to free up time for an execution desk to allow focus on particularly challenging trades in terms of size and/or illiquidity.
5. Transparency and audit trail
Another trend in the FX market is the desire for increased transparency. Using an algo should result in the delivery of an associated post-trade report which provides full details of exactly how each child order was filled, providing a full audit trail of execution prices and time stamps.
Pitfalls
Algos clearly have benefits and can help contribute to achieving best execution in some circumstances, but they are no panacea. There are potential pitfalls to be aware of when using algos, which have been summarised below.
1. Cost vs Performance
Algos are typically charged for in terms of a specified amount per million of notional and costs vary significantly. The temptation is clearly to simply use products that appear to cost the least. However, a product that might appear relatively expensive in terms of headline cost, might on average deliver far superior execution performance when taking into account market impact etc. This, to make informed decisions when comparing products it is important to look at net performance for large enough samples of trades to make the results viable. This is clearly a challenge when each provider provides their own performance data, and in addition, there is a lack of consistency across the metrics and the format it is provided in to allow meaningful comparisons.
2. Market footprint and signalling risk
A key component of performance is how much market impact any one algo may or may not create. There are many ways that algos can interact with liquidity sources and poorly designed algos or sub-optimal selection and management of liquidity sources may create significant market impact. So, if a key execution objective is to minimise impact, it is not a given that an algo will automatically achieve this and indeed, depending on the market conditions, using risk transfer via the phone may at times be a superior execution method.
3. Marketing spin and black boxes
There are hundreds of FX algos now available and navigating the maze of marketing material is not straightforward.
Understanding exactly what a product does can be challenging as providers understandably are protective of their intellectual property. Conversely, there is growing pressure for users to have full disclosure on the details of how an algo actually works. Many market participants are uncomfortable using any product that might be perceived as a ‘black box’, and this is probably one of the reasons that the adoption of algos in FX is still largely concentrated in the more ‘simple’ product types.
4. Liquidity Sources
For algos that access multiple liquidity sources, this can create overhead in terms of monitoring which liquidity providers are delivering high quality liquidity and superior execution.
Algo providers manage these relationships although a client may have specific requirements in terms of where they want their algo orders to be worked and where they don’t.
5. Selection
Given the array of products now available, the process of how to select a specific algo for the trade in question is obviously complex. A number of factors need to be incorporated within the selection process, including if there is an execution benchmark to consider or other execution objectives. With the increased focus on FX execution, it is more important nowadays to be able to record and justify such selection decisions. A rigorous process, informed by independent analytics, provides the foundations for such a selection process by focusing on objective performance measurement.
Conclusions
Algos clearly have a potential role to play in any modern FX execution process, helping provide efficient, transparent execution in a cost effective manner. However, they are no ‘magic bullet’ and won’t necessarily always deliver ‘best’ execution. It is imperative that upon embarking with the use of algos that the potential pitfalls are understood and they are used judiciously and when appropriate to the trading objectives, benchmarks and liquidity conditions. It makes sense to include algos on any menu of execution options and products but it doesn’t make sense to always choose them for every meal.
