Of all the uncertainties surrounding the evolution of financial markets under the weight of regulation, one of the few things that most participants feel sure of is the likely growth of the futures market. As trading volume bulges and participants seek out the most efficient execution channels, the popularity and sophistication of algorithmic tools also looks set to grow.
“When you reach a certain level of activity in futures, using algos starts to yield quite significant benefits and cost savings. We moved to intraday trading a few years ago and now that our trade frequency has increased, we do everything algorithmically to ensure best execution,” says Michael Mundt, principal at Revolution Capital Management, a Colorado-based commodity trading advisor (CTA).
According to research by Tabb Group conducted last year, algo execution accounted for just 4% of buy-side futures volume in the US in 2011, rising to 11% in 2012 and 12% in 2013. That figure was expected to grow to 20% in 2014 and 30% in 2015.
US Buyside Futures Volume by Execution Channel [Source: TABB Group] |
“If FX non-deliverable forwards are required to be cleared, FX futures could see a tremendous boost. Under that scenario, the demand for algos would grow quickly, leading to further advancement of strategies,” |
This projected acceleration in the growth of algorithmic futures execution could be driven partly by the more general growth in the futures market, as regulation of over-the-counter derivatives drives buy-side firms to seek cheaper alternatives. A string of exchanges, including CME Europe, Eurex and Singapore Exchange, have launched FX futures in recent years in the hope of capitalising on any decline in the swaps market.
“If FX non-deliverable forwards are required to be cleared, FX futures could see a tremendous boost. Under that scenario, the demand for algos would grow quickly, leading to further advancement of strategies,” predicts Kevin McPartland, head of market structure research at Greenwich Associates.
DRIVE FOR EFFICIENCIES
The Tabb Group research found that 38% of futures commission merchants (FCMs) expect a significant increase in US futures volume as a result of OTC derivatives market regulation, while a further 50% expect a marginal increase. As the market grows, it is the drive for efficiencies and cost savings that drove the evolution of algos in cash markets that will spur the same trend when it comes to futures.
“Historically there has not been significant adoption of algos in the futures market, but as the flow becomes more electronic and moves more quickly, trade sizes get smaller and interacting with that liquidity becomes more challenging. At that point, there is demand for more sophisticated execution technology,” says Larry Tabb, chief executive of Tabb Group.
While Tabb’s research suggests the growth of futures algos is still in its early stages, a small handful of providers have already looked to cater to the growing demand in recent years.
“We don’t do any proprietary trading or principal activities, only agency algorithmic execution, and our clients have been able to materially evidence the value we can deliver in reducing slippage and cutting transaction costs…” |
For Christian Hauff, chief executive and co-founder of Quantitative Brokers, which specialises in fixed income and futures markets, the light-bulb moment came after working in a number of senior e-commerce roles at Barclays and Bank of America in the years leading up to the financial crisis. During his time at Bank of America, he and co-founder Robert Almgren recognised an opportunity to develop more sophisticated execution models and transaction cost analysis for the fixed income and futures markets.
As a registered broker-dealer, Quantitative Brokers offers a suite of four algorithmic strategies, including an arrival price algo and an algo that aims to beat volume- or time-weighted average prices. Having done its first trade in 2010, the firm has seen momentum building in recent years as its client base has expanded beyond the systematic CTAs it initially targeted. The firm now counts a broader range of funds, including discretionary as well as systematic, among its client base.
“We don’t do any proprietary trading or principal activities, only agency algorithmic execution, and our clients have been able to materially evidence the value we can deliver in reducing slippage and cutting transaction costs – it’s a meaningful saving per unit traded, which can be easily measured,” says Hauff.
VALUE OF ALGOS
For Mundt of Revolution Capital Management, the value of algos can be distilled down into how much can be saved when putting on and taking off trades. Often that means finding a strategy that can strike the right balance between a passive and active approach to avoid crossing the bid-ask spread (being forced to buy at the offer price or sell at the bid).
Futures Algorithm by Geographic Region |
“Many of the early algos in the futures market had been ported across from equities and tended to cross the spread a lot – in the futures market, the spread is much bigger than in equities, so it wastes a lot more money. A good algo needs some passivity without being so passive that prices start running away from it,” says Mundt.For providers, it became clear that the specific features of the futures market called for a different approach than the VWAP and TWAP algos that have been widely used in the equity markets.
J.P. Morgan last year launched a futures algo known as Aqua, which is designed to optimise execution across a large range of futures markets to which it is connected. Aqua uses a number of signals to determine how aggressive or passive it should be, in keeping with buy-side demand to control impact, capture spread and source liquidity. “Aqua effectively emulates the behaviour of a trader who has the time, experience and intuition to maximise spread capture and minimise market impact. The aim is to create a strategy with the right degree of flexibility so that users can set their own appetite for risk and market impact,” says Peter Ward, global head of futures and options execution services at JP Morgan.
 “We are working towards marrying up signals with order placements, so that clients can see how each order and slice performed and review why individual orders traded in the way they did.” |
 “A good algo needs some passivity without being so passive that prices start running away from it,”
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TCA
As with any market, the provision of algo execution tools must go hand-in-hand with transaction cost analysis (TCA), to enable buy-side firms to benchmark their performance and show proof of best execution to their clients and shareholders.
The value of TCA depends to some extent on building up a reliable data set from historical orders, which clearly takes time, but innovative technology and user interfaces also play their part in illustrating to a range of audiences the economic value that can be achieved through algorithms.
“We have invested heavily in our TCA platform over the years, and used it initially to stimulate debate internally about the best designs for our algos. We had the benefit of building from scratch so we were able to design the best visualisation, with greater accuracy and precision than some of the legacy providers,” says Hauff of Quantitative Brokers.
 “…for other buy-side firms, it is getting better and cheaper for them to use sell-side algos rather than spending money in-house,” |
Developing TCA technology is somewhat more straightforward in the futures market than in spot FX, because exchanges provide reliable market data that can be used as a benchmark. In the FX market, TCA providers have found it harder to deliver credible services when liquidity is fragmented across so many different platforms and there is no consolidated market data available.
JP Morgan has invested heavily in TCA to support its electronic businesses. Through the JP Morgan Markets portal, users can slice and dice their order flow to analyse performance against various benchmarks, and Ward believes there may be value in developing more detailed post-trade analysis. “We are working towards marrying up signals with order placements, so that clients can see how each order and slice performed and review why individual orders traded in the way they did. This kind of analysis is crucial if firms are to really benefit from algos,” says Ward.
CUSTOMISATION
Offering some degree of customisation is also likely to be an area of differentiation between algo providers in the future. While the most popular algos have become commoditised over the years, many CTAs are seeking solutions that can meet the specificities of their own strategies.
Revolution Capital Management has developed a hybrid approach in which it uses banks’ off-the-shelf offerings as a benchmark, but looks to deploy more customised algos to suit the specific requirements of its trading programmes.
“There is certainly some commoditisation of strategies and you tend to get more or less the same results from one bank to another, which is why there is a move towards customisation. The advantage is that we don’t have to spend time and money building algos ourselves, but can present banks with our wish list of functionality,” says Mundt.
 Futures Algo Strategies and Estimated Percent of the Market |
For quantitative hedge funds that have historically built their own algos and may be reluctant to use commoditised tools, the potential to source customised technology could be an effective compromise. And as the sophistication of bank and broker provided tools rises, it makes less sense for firms to spend significant resources in-house.
“Market markers will continue to develop their own algos, because they need to be developed specifically depending on how they make markets, but for other buy-side firms, it is getting better and cheaper for them to use sell-side algos rather than spending money in-house,” says Tabb.
In the long term, while there will always be points of differentiation, most participants and observers share the view that algo execution is poised for growth in the futures market, which can only be good news for providers.
“Algo usage by investors in futures and more specifically FX remains limited, despite the high level of electronic trading. As such, a huge opportunity still exists for algo providers that can improve investment outcomes for their clients,” says McPartland of Greenwich Associates.
