The FX Algo market has gone from strength to strength, and the level of technical capability has increased exponentially. Clients are reaping the benefits of using this technology to access the market without signaling intent and there has been a significant and increasing choice over how their executions are handled. Best market access and post-trade TCA have become essential tools to demonstrate optimal execution. So, the question is, what has been missing from this equation to improve these executions further and give any institution an edge over their peers when running algos for their clients?
As a client, how do I know that any institution I use for algo execution has better market access than its peers? There are several educated guesses in terms of size, geographic reach, and the number of relationships. However, at its core, market access is also determined by counterparty credit and the number of diverse counterparty relationships.
Some observations
There are several clear observations to be made in this regard. First, there is the global presence of the institution and the number of trading relationships it has. There should be a natural business of diverse executions allowing for optional natural offsets, as an internal offsetting trade is always much more profitable than a brokered venue execution. There has been little discussion about optimizing credit for market access purposes because there is a perception that it is not an issue, particularly for major counterparties and CLS currencies.
What has become clear from the studies we have conducted, however, is that any person or algo that executes in the FX market will miss executions where credit is limited, or limit up, and crucially, the executing mechanism is unaware that it has missed a better execution because missing credit is never seen. In short, you don’t miss what you don’t see, but you and your algo client miss out. Another way to think about this is always keeping you gun barrel clean, as you do not know when you need to use it. In short, credit should be continually optimized, ready to go for the best outcome.
For existing Bank clients, we have been focused on eliminating carve outs in favor of a centralized approach to credit. This not only addresses the systemic risk of over allocation that regulators are particularly interested in, but it also provides better control and gives credit management teams the ability to monitor for genuine limit up scenarios, not the false ones caused by carve-outs.
What is blatantly clear is that this approach provides fully optimized market access and further analysis has shown that much less credit is required for even deeper liquidity, proving the waste and lack of control. Conversely, it means that more restricted credit limits can come into play where they previously were not available. This benefit is particularly true at the short end of the curve, where spot and settlement risk are very important but also for FX Derivatives, where credit is typically more constrained. This is a true win-win scenario.
Additional credit algorithms can also reopen market access credit in a virtuous cycle of execution and market access optimization to keep those limits fully available. This is particularly important for more illiquid currencies and credit-constrained counterparties and very importantly your execution counterparty does not have to be your exposure or settlement party.
Some algo providers have already recognized the role that credit plays in market access and are already reaping the rewards of optimized credit limits. Clients should now start to ask their algo execution providers if they use these essential credit tools to ensure executions are improved even further.
