Algorithmic trading has exploded in the FX market in the past two years, the fast pace and high liquidity of the FX world making a perfect asset class for this sophisticated trading. Traders are now able to supplement screen based trading with faster, smoother and more efficient automated dealing mechanisms. However, it has signalled a changing of the guard; control over pricing is shifting away from banks that must now come to terms with a client base that is acting more as counterparty. In response, banks are investing heavily in updating advanced trading systems, including rate engines, price sourcing and price distribution applications, to try and keep pace with the evolving market.
Growth in FX Volumes
Since 2001, the FX market has experienced stellar growth, both in volumes and sophistication. A primary driving force behind this growth has been the entry of new market participants, such as hedge funds, and the buy-side who are using FX in the hope of achieving higher investment returns in comparison to the mediocre and volatile returns found in other asset classes, particularly equities. It also coincides with the globalisation of the equities and fixed income markets.
Their arrival has been mirrored by a simultaneous growth in the sophistication of platforms available. Substantial investment has been sunk into new technologies, such as pricing engines in order to stream executable prices with reduced latency. Although its spread was gradual at first, electronic foreign exchange trading became increasingly common, and the term e-FX was soon on everyone’s lips. Evidence of the rapid rise in the uptake of e-FX in the past couple of years is reported in a study from Greenwich Associates, which shows e-FX volumes more than doubled between 2003 and 2004, and that growth is expected to continue. By 2007, electronic foreign exchange is expected to comprise more than 60% of all FX trades from just 40% in 2004.
Whether the changes to foreign exchange trading have come about because hedge funds were demanding them or because banks deployed them in the hope of attracting new business, is debateable. What is clear is that they have opened up a range of new opportunities for all parties. The most successful organisations have been those that have invested most heavily in enhanced technology and infrastructure as they are better prepared to handle large increases in trade flows.
Arrival of Algo Trading
Algorithmic trading has only truly emerged in FX over the past year, but uptake has been remarkable. Previously utilised predominantly in electronic markets that are exchange traded (e.g. equities) algorithmic trading is now being rolled out across a variety of asset classes. This move is prompted by factors such as excessive growth of trading volume in some sectors, fragmentation brought about by electronic trading and increasing convergence within the industry, particularly the demand for multiple asset class trading. Larger organisations were quick to adopt these new instruments, but their use is already filtering down throughout the whole sector.
Despite substantial differences between asset classes, FX is particularly suited to algorithmic trading because of the high levels of liquidity and the growing use of electronic trading. Although still new to the market, algo trading in FX is being accepted vigorously and is expected to become more common throughout the course of 2007.
Driving the use of algorithmic trading strategies are hedge funds, high-frequency traders, and proprietary traders as evidenced by increased activity on systems such as EBS, Reuters, Currenex, and Hotspot FX, as well as rapid growth of FX futures trading at the Chicago Mercantile Exchange (CME).
The increased use of algorithmic trading strategies is generating huge growth rates within the FX market. The automated process has helped maximise the performance of human spot traders, who might previously have been distracted by smaller deals. These can now be processed via fully automated black box algorithms, leaving traders free to concentrate on larger, more lucrative deals.
Balance of Power
However, not everyone has greeted the new hi-tech environment with unbridled enthusiasm; indeed some have argued that the last thing the FX market needs are alternative venues and the adoption of technology is causing more problems than it solves. Along with greater functionality, these platforms have increased complexity and fragmentation within the market.
Thanks to the multiplicity of trading venues, it is difficult to know precisely where to access liquidity when moving large sums of money. Because traders are putting prices out on multiple venues simultaneously, an illusion is sometimes created that more liquidity is available than is, in fact, the case. This has been a thorn in the side of many banks and most have pondered, at one time or another, the value of creating a separate fund to hedge against possible liquidity mirage.
Algorithmic trading has also had the knock-on effect of altering the balance of power between the bank and its own clients. Traditionally, banks have held control over the price and spreads within FX, but it now appears that power is progressively being lessened. Algorithmic trading enables the buyer and seller to gain competitive advantage by timing their entry and exit into the market. They are now able to make price on a large amount in the same way as a bank, which means some are finding themselves well placed to act as the aggressor in the market, or even as a market maker. Banks with less efficient systems have found themselves at a significant competitive disadvantage. Some of the major banks, therefore, have responded by attempting to limit the access to trading platforms, inviting accusations of some attempting to set up exclusive trading platforms.
This has led to a certain amount of opportunistic trading – trading that appeared at first sight to be ‘algorithmic’ but was in fact latency arbitrage. Multiple firms can link to two or three venues and play off against inefficiencies within the market. Finding ways to put a stop to this and eliminate illusionary algorithmic trading practices is central to banks’ strategies for the future.
The Technological Arms Race
This faster moving and more competitive environment forces all parties to up their game, and the quest for better technology is proving crucial. There is currently a great deal of focus on using more advanced platforms, such as Flextrade and Trader Tools, to aggregate various execution venues. Inefficient software or networks can trigger substantial market losses. The race is on to find new ways to take advantage of the market and the victors will be those with the fastest computers, most advanced software and better access to market prices.
The challenge of adapting workable solutions is a daunting one. The global nature of FX adds yet more layers of complexity. Banks must come up with multiple solutions that will work in a multi-environment marketplace. A European bank must develop solutions that can service the US market and the Asian market, with all the different time zones in all the regions included. Just because a model works in Europe, doesn’t mean it will work around the globe. Speed is a key factor, but unless networks are well integrated with software, problems can be exacerbated rather than solved.
If applied correctly, algorithms can mitigate against complexity caused by e-FX by presenting organisations with a much clearer and more accurate view of the market. Most important is the ability to avoid latency. Depending on where and how they connect, banks are better equipped to deliver ultra-low latency and in turn avoid association with those unscrupulous organisations that may have been previously taking advantage of inefficiencies within the market.
What the Future Holds
The FX market will continue to expand and grow. Although indications are that the rapid growth of the last couple of years will level out, activity is expected to continue at a steady and sustainable pace. Electronic trading will also grow, with work already underway to find ways of expanding it into more currencies as well as areas in which it is not currently present, such as non-deliverable forwards (NDFs) and FX option premiums.
The whole playing field has changed dramatically, encouraging participants to be more strategic in how they push their rates out, how they go about it from a networking point of view and how they connect with their clients. The old days of working via the Internet and utilising conversational trading will soon be gone, and everyone is racing to catch those clients who are already doing everything electronically and have sophisticated models which they want to trade.
Electronic trading certainly has thrown the cat among the pigeons where FX is concerned. It has already led to some remarkable changes within the market, but it has the potential to do even more. Having experienced an unprecedented level of control, the buy side is likely to become even more ambitious, while for the bank market, the challenge is to evolve to keep pace.