Segregated Execution – removing conflicts of interest in the FX algo trading process

In this, the first of a series of regular features we are
publishing, Carlos Gomez Gascon, Head of FX Algorithmic Execution at JP Morgan tackles a few of the questions buy
side firms have about the topic of segregated execution.

Carlos Gomez Gascon
Carlos Gomez Gascon

FX is highly liquid; do I really need Algorithmic Execution?

With the proliferation of electronic platforms OTC markets, in particular FX are highly fragmented. The execution of a simple EURUSD order may require up to 5 different venues in multiple regions to truly minimize cost and access liquidity effectively.Algorithms act as an effective utility in allowing users to automate complex logic to access markets, whilst allowing them to focus on broader macro/execution themes. The objective of an algorithm is to inherently reduce the execution cost as compared with the visible spread on a risk transfer for the same size; however, this is based on the underlying liquidity and logic in the algorithm.

What are the differences between Agent and Principal1 execution in FX Algorithmic execution?

Typically, FX and similar OTC markets exhibit a high concentration of principal market makers that traditionally warehouse risk and manage inventory; of the $1.65trn daily spot volume executed, they make up over 605bio of this volume according to the last BIS Triennial survey2. Executing an algo via a principal market maker allows a user to maximize the value of the reciprocal risk from the principal market maker as well as the open interest on public venues. For an algo provider executing as an agent, the liquidity will be limited to visible interest on public channels as well as intermittent algo matching. Scheduling and routing may be similar for both Agent and Principal providers, however, market impact and cost will vary due to the amount and quality of available liquidity.

Where is the conflict of interest?

Whilst offering reciprocal risk for Algorithmic execution is an excellent strategy in minimizing client costs when Principal market makers are active in a similar instrument and direction as that of the client executing an algorithmic order, conflicts of interest can arise. 

How does a principal Algo provider resolve this conflict?
Appropriate processes to segregate information to prevent Principal traders from accessing algorithmic orders information mitigate conflicts of interest. Principal market makers are still able to exchange reciprocal risk by posting liquidity which can be accessed at the algorithmic order’s discretion. 

What should be the visibility boundaries for algorithmic execution flow?

A key instrument to define visibility is the need to know basis to effectively perform the job function.
Dedicated electronic Sales and client support teams help clients navigate the electronic execution offering, providing input before, during and after execution. Development teams in charge of creating and supporting the pipeline will require access to verify and support in-depth technical questions effectively and in a timely manner.

In scenarios where clients feel the need for their traditional voice sales coverage to provide assistance on their electronic orders, providers should work with them to understand and try meet the client expectations and requirements. This should be assessed on a client per client basis.

Who do you face in Algorithmic Execution?

In FX Algorithmic Execution (besides pure agency3) typically both clients and market execution liquidity face the algorithmic trading provider. This enables the end user of algorithmic orders to remain anonymous and access the public market under the provider name.

Does size matter for public venues’ anonymity?

Larger algorithmic execution providers are expected to have more recurrent two way flows in public venues. This high amount of volume traded helps disguise episodic larger trades from users, potentially reducing information dissemination and market impact whilst utilizing provider liquidity capacities.

  1. Agent means in this context that it can only access external public venues whereas Principal provides in addition access to internal liquidity from the provider.
  3. Pure agency here refers to the client having a direct relationship with public venues , accessing liquidity under their own name and transferring trades directly into their books without hitting the algorithmic provider books temporarily.

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