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19 November 2012

Four Barriers to Execution Quality in FX

Institutional clients are beginning to analyze execution quality in an effort to reduce their FX trading costs. But several barriers have to be overcome to improve execution quality.

Understanding and improving execution quality is an emerging discipline. Pricing is not normalized in FX. Different customers will receive different prices based on their risk, margin, trading style, etc. But an increasing number of institutional and corporate clients are beginning to analyze execution quality in an effort to reduce their foreign currency trading costs. 

TCA is Seeing Growing Adoption in FX

Research published by Greenwich Associates based on a poll of 232 buyside traders finds that 41% of the world’s largest institutions are employing some kind of transaction cost analysis (TCA) in their FX trading process. State pension funds have captured headlines with lawsuits against custodial banks for their methods and timing of execution on standing instruction trades. As a result of these conflicts, a growing number of clients are migrating away from standing instruction or indirect trades to use methods that can get better execution quality and improve overall FX trading results.

But improving execution quality requires an understanding of how the markets work. It’s also not just a buy-side issue. Market makers at the banks also need to carefully manage FX trading profitability and risk. There are a number of issues that can affect execution quality.

Latency Hurts Both Clients and Market Makers

Latency negatively affects both the client and the market maker. For the client, latency can cause prices to be stale, resulting in orders against prices that are no longer valid. For the market maker, latency has an even bigger impact. If the price feeds reaching the market maker are not up to the microsecond, then their ability to publish prices and hedge incoming orders is compromised. If their downstream price feeds experience latency, then customers are acting on prices that are no longer representative of the market.

If customers are experiencing latency, then their orders are hitting prices that are no longer valid and the market may have moved away from those prices in a negative direction. Banks manage this risk by colocating with venues to reduce latency, placing tight time-to-live parameters on downstream prices, and effecting last look functionality on clients whom they suspect of having latency issues. Last looking allows the market maker to check the market prices before accepting an order from a client. But it can result in slippage and reduced execution quality for the client.

High Frequency Trading Makes it a Dangerous Market

High frequency traders (HFTs) make it a more dangerous market for liquidity providers. HFTs use latency arbitrage strategies to pick off the slower market makers. They can create substantial risk for banks when they sweep a market, removing quoted liquidity not only from the banks, but also from the primary markets where the banks expected to lay off their risk.

HFT makes FX trading a more unforgiving marketplace, and creates a technology arms race that results in diminishing returns for liquidity providers. Historically, banks have had difficulty keeping ahead of the leaner, more nimble proprietary trading shops. But banks are getting more sophisticated at market making. The most sophisticated can categorize flow to identify those sweeping the markets. They can identify flow that is tightly correlated to the market, and tiered pricing streams allow them to segment clients, moving unforgiving flow to wider prices in order to minimize risk.

Aggregation Can Hurt Results

FX trading remains a relationship-centered business. From the perspective of the liquidity provider, it’s all about quality and quantity. They’re looking for clients that will give them good flow and allow them to make a fair profit. For most banks, the best quality flow comes from clients who are not aggregating too many providers. If an order gets spread across too many sources of liquidity, no one gains. Over time, this will damage relationships and result in wider spreads and lower execution quality, especially in times of market volatility and thin liquidity.

For the buyside and tier 2 sell side, aggregation can make a big difference in improving liquidity and pricing. But it can also be a way for a trading organization to shoot itself in the foot. The FX marketplace is a web of intermingled liquidity. For example, a client might aggregate a bank and an ECN and sweep both simultaneously. In this case, the client is taking liquidity from the ECN and can potentially move the market under the bank. If this happens often, the client may upset its relationship with the bank because the bank will perceive the flow as highly correlated to the market and may widen prices it sends to that client in order to manage risk. Some ECNs like Hotspot are also able to identify specific client behavior. At the request of a liquidity provider, they can shut down flow from undesirable clients. This helps the banks continue to provide liquidity to the market while managing their risk. But the effect to the client is reduced liquidity and wider spreads.

These and many other business and technical issues can affect execution quality. An expert panel -- including Hugh Whelan, the head of FX eCommerce Market Development and Connectivity at CommerzBank, Bill Goodbody, Managing Director of Knight Hotspot, Peter Atkinson, FX Product Manager at smartTrade Technologies, and James Walker Vice President, Managed Networks Services at Tata Communications -- will discuss these and other execution quality issues during a live webcast scheduled for Tuesday, November 20, at 11:00 EST. Join the conversation. Click here for more information and to register. (A recording of the event will be available as well.)

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