A new study from Coalition Greenwich finds that the disruptions caused by the COVID-19 crisis may have long-term effects on the behavior of FX market participants. At the onset of the work-from-home government mandates, traders turned to their most well established and trusted relationships to navigate the volatility, often via the telephone. However, many traders also increased their use of algos as a means of accessing much-needed liquidity and now despite many traders returning to the office, they expect their usage of algos to continue moving forward. More than 40% of financial FX traders employed algos in 2020. Nearly the same share expect their usage of FX algos to increase in the next year.
“Financial institutions are looking at the efficacy of their algo strategy and are finding that algos can be highly effective, especially at working particularly large orders over time,” says Brad Tingley, Research Manager in the Coalition Greenwich Market Structure and Technology group and author of FX Trading Beyond the COVID-19 Crisis.
According to financial institutions that the Coalition Greenwich team spoke to, increased use of algos ranked second in terms of behavior that will persist beyond the COVID-19 crisis. Anecdotally, the firm heard that the number of small tickets in FX has increased post crisis. Many speculate that this is due to increased usage of algo activity, and the Coalition Greenwich data validates this hypothesis – 38% of financial investors expect their increased usage of algos to continue and 30% of FX users said they would continue to break up larger orders into smaller ones. Considering that 42% of financial institutions use algos to execute FX trades, this is a ringing endorsement of their efficacy.
On average, these algo users execute approximately 25% of their flow via algos. The most popular type of algo used by FX traders are passive, used by 64% of users in 2020. Liquidity-seeking algos rank second in terms of broad adoption, used by 56% of financial-algo-using firms. As a result of the lack of a centralized reporting regime in FX markets, volume-weighted average price (VWAP) algos are less popular than their time-weighted (TWAP) cousins, an important distinction from U.S. equity markets.
Source: Coalition Greenwich 2020 Market Structure & Trading Technology Study
Despite the fact that the volume traded at any given price cannot be known with certainty, nearly 30% of financial institutions still utilize VWAP algos. For nearly half of respondents, it appears that TWAP serves as an effective proxy for VWAP. Especially in the most liquid pairs, the intraday liquidity remains roughly consistent (or at least consistent enough) for traders to continue substituting TWAP for VWAP, especially when considering that FX trading is often a second-order hedge rather than an alpha generator.
Source: Coalition Greenwich 2020 Market Structure & Trading Technology Study
In addition to asking which types of algos they use, Coalition Greenwich also asked study respondents how likely they were to use algos in a variety of circumstances. Financial institutions were most likely to use algos when they have a large order to work over time or when market conditions are stable (which may have dampened the overall uptake in algo usage, since 2020 was anything but stable). Given the types of algos used, these results make sense, as the most popular algo type used among FX traders is passive.
Intraday liquidity remains roughly consistent for traders to continue substituting TWAP for VWAP
Despite liquidity-seeking algos being used by over half of respondents, traders are less likely to use algos when market conditions are volatile or when they have a large order that needs to be done quickly. This is likely due to the increased importance of relationships felt in FX markets during the COVID-19 crisis, when traders have been more likely to rely on their dealer counterparties to help navigate the unknown.
Nevertheless, broad adoption of liquidity-seeking algos demonstrates that traders are equipped for any scenario, and when they just want out of a position, these algos can be a critical tool. For the 17% of respondents who said it was a certainty they’d use algos when they have a large order that needs to be done quickly, perhaps liquidity-seeking algos can be best described as: In Case of Emergency, Break Glass.
Conclusion
Summarising the findings from the study, Brad Tingley says that, “The COVID-19 crisis further highlights the importance of relationships despite the highly electronified nature of the FX market. It also beckoned some noteworthy behavior shifts such as the use of algos and developments in auto-execution that are likely to persist in the coming years. Algos continue to be a critical tool for traders to utilize, despite some of the shortcomings presented by the nature of FX markets and the lack of centralized data sources.
As a result, we are keeping our eyes open to developments in FX transaction cost analysis, as effective trading benchmarks will help not only in meeting best execution requirements, but also determining execution behaviors in the years to come.”
