Foreign exchange trading has been placed under the microscope in recent years, as a series of high-profile scandals and investigations has led regulators and investors to examine trade execution practices more closely.
An increased focus on best execution is one consequence, with buy-side firms facing much greater pressure from their own clients to prove that they have sourced the best deal.
“We are in an environment where the market structure is evolving at a rapid pace with the implementation of new regulation and practices. These changes, along with structural changes in FX liquidity and the continued migration towards electronic trading, have contributed to the quest for best execution becoming more widespread in foreign exchange,” says Robbie Boukhoufane, global head of FX trading at Schroders.
To some extent, best execution should always have been the natural objective of a trading desk, given the fundamental need to get the best deal for clients through competitive pricing. But as the FX market has evolved, with trading volume increasing and a greater diversity of execution channels available to the buy side, proving best execution has become both more important and more complicated.
According to a report published by Aite Group in March, Buy-Side FX Outlook 2015: Measuring Up to Best Execution, 78% of buy-side respondents already have an in-house best execution policy in place for FX, while the remaining 22% are planning to create one.
“As part of their fiduciary duty to asset owners, asset managers have an obligation to ensure best execution, but it’s gradual process for this to become an accepted and widely used practice. We have seen it take hold in the equity market over several decades, and it is now spreading to FX,” says Howard Tai, senior analyst at Aite Group and author of the report.
Recent revelations that some FX spot traders within banks had shared confidential client information and colluded to manipulate benchmark exchange rates have pushed best execution much higher up the agenda of buy-side firms. In many cases, asset managers now face greater pressure from asset owners to prove they are handling the execution of FX trades appropriately.
“Given the dependency on bank liquidity within foreign exchange, the benchmark scandal and ongoing investigations into various market practices at the banks demonstrates that asset managers need to review and assess their different methods of FX execution and give justification as to how any execution process operates,” says Boukhoufane.
 “TCA should be seen as a way to improve the strategy of end users across the entire order lifecycle so that they can achieve best execution rather than just best price,” |
That pressure to achieve best execution means the style of trading on many buy-side desks is changing, with long-standing counterparty relationships increasingly playing second fiddle to solid execution data. Where a trader might previously have had a strong relationship with particular counterparts on the sell side and directed flow accordingly, such decisions now need to be justified more transparently by past performance.
One of the challenges of accurately proving best execution is that it tends to mean different things to different people. Most firms agree that it encompasses more than just best price, but there are multiple other factors that could be considered to be important.
When seeking best execution, the Aite Group report suggests, buy-side firms must also consider whether trades can settle via straight-through processing without incurring errors, which can be costly and resource-intensive to correct. Attention should also be paid to the quality of investment research and strategy advice available from the sell side.
Execution certainty is another important consideration, adds Steve Aldridge, head of macro electronic sales for Europe, the Middle East and Africa at Credit Suisse. “Best execution is far more than just the best price, as customers consider a range of factors when reviewing the quality of their executions. Certainty of execution is an important consideration in the principal risk transfer world while additional costs, such as prime brokerage fees are also taken into account,” he says.
Defining and proving best execution in a consistent way across the industry may be difficult at this stage in its evolution, but the rising volume of information available to buy-side firms means they can now use data to benchmark performance more easily than in the past, even if they are not yet tapping advanced transaction cost analysis (TCA).
“Buy-side firms have always sought best execution, but while in the past this may have been achieved on a price comparison basis clients are now much better equipped to analyse execution quality in more detail and source information from multiple angles,” says Evangelos Maniatopoulos, Global Head of AES FX product and trading at Credit Suisse.
USE OF ALGO EXECUTION STRATEGIES
 “Algo execution may not make up a large proportion of flow in the FX market, but we are seeing active growth in a number of different client segments…” |
If best execution is accepted to be the primary objective for the buy-side trading desk, some believe algo execution strategies offer the optimal route to achieving it. By pre-defining the parameters within which an algo will execute, portfolio managers can take greater control of their orders and present a clearer audit trail to their clients than they might through traditional voice channels.
But while the popularity of algos has certainly increased in recent years as a wider range of clients have experimented with basic strategies, usage varies significantly across the industry.
According to the Aite Group report, 56% of respondents, accounting for 13 firms, are currently using FX algos. Of those 13 firms, 9 said that algos accounted for 1-10% of their FX volume, while only one firm said that it accounted for more than 50%.
“Algo execution may not make up a large proportion of flow in the FX market, but we are seeing active growth in a number of different client segments, and we are developing new functionality across the full trade lifecycle to cater to this growing demand,” says Maniatopoulos of Credit Suisse.
But some firms remain lukewarm, warning that algo execution may work well in certain circumstances, but should not be seen as a panacea in the pursuit of best execution. Boukhoufane of Schroders sees algos as one of a number of trading tools that are required to achieve strong performance across the portfolio.
“In my experience there are certain market environments, and in particular certain currency pairs, where the use of an algo strategy can reduce market impact and improve execution. However, at this point in time the use of an algo is simply another tool we have at our disposal to access liquidity, in addition to request for quote, request for stream and voice trading,” Boukhoufane explains.
INCREASED UPTAKE OF ALGOS
It remains to be seen how much more FX business could be executed algorithmically in the future, but some providers believe the more widespread focus on best execution will inevitably drive increased uptake of algos across the industry.
“Buy-side firms have always sought best execution intrinsically, but there is now a push for them to prove best execution on a fill-by-fill basis. The enhanced precision delivered by algos offers the best way to achieve that because of the clear execution data, time stamps and TCA,” says John Colasanti, FX sales at ITG.
 “Best execution is far more than just the best price… |
As the popularity of algos has increased in recent years, so too has the number of banks and technology vendors providing algo execution tools. Credit Suisse and Citi may have been first movers in FX, just as they were in equities, but the majority of top-tier banks now offer some form of algo execution to their FX clients. That creates a more diverse product set for the buy side, but it also means firms must properly assess the value of individual offerings when making their selection.
“I do believe the use of algorithmic trading strategies will continue to evolve but at this stage we have some concerns over the number of companies coming into the arena. In some cases there is a lack of transparency with regard to how many of the algorithms operate and source liquidity. The responsibility is on the buy side firm to carry out due diligence on any algorithm used,” says Boukhoufane.
Proving to clients that the costs incurred when using a particular algorithm were compensated by the enhanced performance of the strategy creates an additional burden that buy-side firms need to consider when weighing up their execution choices.
ROLE OF TCA
TCA plays a fundamental role in providing the data on past performance to help firms navigate the diversity of algo offerings available in the marketplace. The technology underpinning TCA has come a long way in the FX market in recent years, but it has always been more challenging than in the equity market due to the lack of a central source of FX data.
“To provide meaningful TCA, providers need a solid data set and an understanding of the market structure. When you look at executions happening in microseconds, it’s crucial to have enough quality data to benchmark those fills immediately and report the analysis back to the end user,” says Colasanti.
Of the firms surveyed by Aite Group, 78% were already using TCA in foreign exchange, while 13% were planning to begin a TCA study in the near future. All of those firms have used post-trade TCA to evaluate their trading performance, while 28% used pre-trade TCA to determine their choice of trading venue, highlighting the rising complexity of analysis available.
“TCA is mainly used in a post-trade format in the FX market at the moment because the technology is now fairly well-developed to analyse trade performance after the fact. It should be seen as a way to improve the strategy of end users across the entire order lifecycle so that they can achieve best execution rather than just best price,” says Tai.
While pre-trade and real-time trade analytics may be less well-developed than post-trade TCA at this stage, having technology that can support the making of trade decisions rather than just benchmarking on a post-trade basis may be more valuable to end users in the long term.
“One of the more exciting aspects of TCA is the pre-trade analytics, which a very small number of banks have an edge in. This functionality is evolving and giving the buy-side trader the ability to assess the liquidity dynamics of any given trade prior to execution, which can then influence the method of execution,” says Boukhoufane.
In general, he adds, TCA is a central tool in proving best execution, but it is not yet as accurate as it needs to be across the market. “As FX is an OTC market there are still some question marks over the reliability of data that TCA providers can access, particularly in emerging market currencies and forward curves, but for the more liquid currencies reliable data is accessible. My view is that the access and analysis of this data will evolve at a rapid pace, which will mean execution performance will become much more transparent.”
