Despite the dominance of over-the-counter (OTC) trading in today’s FX market, the rapidly evolving regulatory landscape will lead managers to consider alternatives in today’s cost-conscious environment. Global regulations for margin calculations, capital requirements and mandatory clearing are increasing the appeal of futures as an execution vehicle.
Consultancy Oliver Wyman projects that FX futures will provide 40-70% savings on margin costs for institutions subject to Basel III. As firms see the cost-efficiencies in futures, instead of OTC products, they should see growing interest from a breadth of both buy and sell side traders interested in averting the more heavily regulated, standardized products. But traders entering the FX futures markets can harness more than the expected margin benefits by taking the opportunity to invest in cutting edge execution strategies.
In the highly fragmented, rapidly developing FX markets few traders are fully leveraging the capabilities of algorithms. Heightened awareness of execution quality has stimulated mass market migration to algorithmic execution in some asset classes, but the trend is yet to take hold in FX.
Recent research from Greenwich Associates expected the usage of FX algorithms by the buy-side to reach 18% by the end of 2014. This is solid growth from the 7% in 2012, but still a remarkably small percentage in a market where 80% of volumes are executed electronically. It’s clear that the majority of firms operating in FX markets don’t realize the potential of algorithmic execution in a market that naturally lends itself to an electronic environment.
Fortunately, the heightened scrutiny of best execution practices in the wake of the Financial Conduct Authority’s July 2014 report is increasing awareness of the tangible value of investing in algorithmic execution.
Concepts like transaction cost analysis (TCA), smart-order routing, hidden liquidity and implicit vs. explicit costs, which are staples of best execution, are often undervalued or misunderstood in the OTC markets. This has lead many firms to view external algorithms as an unnecessary expense, rather than an investment with robust returns.
But this is all due to change, as regulatory bodies are moving closer to best execution mandates that will further progress the emergence of execution algorithms. Offerings like the CME electronic FX futures complex will continue to grow as an alternative to OTC FX markets, as the benefits of a transparent and anonymous trading environment are appealing. Exchange structure, fully disclosed fees, clearing and mitigation of counter party credit risk are key pieces in the evolution of FX futures into a dominant investment product.
When coupled with recent attempts at manipulating FX benchmark rates by some major bulge bracket banks, buy-side traders are likely to shift some FX flows to these transparent platforms. These factors will provide even greater opportunity for firms to use execution algorithms to beat spreads and maximize returns. Understanding the principles of algorithmic execution, and investing in the sophisticated strategies that save alpha will be paramount to success for buy and sell side traders moving to FX futures. They can’t afford anything less than best execution in the emerging speedway of FX futures.