Something has to give: Pressure builds in FX execution

The struggle for margin in trading in FX is driving innovation, but not without pain. Dan Barnes reports.

Research by analyst firm, Coalition Greenwich, has highlighted a struggle at the heart of FX trading as the pressure to increase efficiency, within regulatory parameters, is crushing margins. Simultaneously, that pressure is leading to appetite for less intermediation and greater automation.

Thomas Jacques, principal, strategy and data consulting at Coalition-Greenwich and author of the report, ‘End-to-End Value Chain in Electronic Markets: A Costs- vs. Spreads-Driven Evolution’ says, “The consensus we hear is that multi-dealer FX flow is extremely hard to monetise.”

In the report JP Morgan provided data showing that its FX margins for multi-dealer platform trading were at zero for Q3 and Q4 2020.

More broadly dealer revenues are dropping. In Q1 2021, Coalition Greenwich found that sellside G10 FX revenues fell, based on lower client activity combined with reduced risk appetite and significantly lower volatility compared to Q1 2020, with revenues falling across regions, spreads continuing to tighten and emerging markets’ FX revenues dropping across regions.

To reduce their costs in spot FX trading, sellside liquidity providers (LPs) are advocating more direct streaming of prices to buyside desks, thereby avoiding the fees charged by multi-dealer platforms. Yet in other FX instruments, trading on venues looks more interesting, particularly as buyside firms seek to increase their ability to hedge and to manage alpha generating opportunities with FX options and futures.

“Options are potentially becoming a bigger part of the FX world,” says Daniel Chambers, head of data & analytics at BidFX. “Market participants are trying to leverage what has been developed in options trading in other products, and transferring that over to FX trading. I think the other area is futures. So, particularly with the regulations around clearing and so on, there are reasons why futures trading might be preferential to the more typical trading on an over-the-counter (OTC) market.”

Whilst the drive for efficiency is pushing traders on both sides of the street towards lower cost routes of engagement there are some intrinsic challenges. One is the best execution provision, which requires buyside firms to get the best trading result on behalf of their clients – often the lowest cost in flow products like FX.

Another is the capacity of buyside firms to engage with trading in more complex products, and to engage with their counterparties.

Ready for change
Buyside and sellside relationships are always tense in OTC markets, as the profitability of dealers hinges on the bid-ask spread they can charge their clients, and on volume. Buyside clients seek to minimise spread and reduce trading volume where possible, in order to cut unnecessary costs.

A lack of transparency and perceived poor behaviour in FX trading led to the FX Global Code of Conduct being printed in 2017, and revised in 2018, which has created a common set of behaviours for dealers to follow. Yet it is up to buyside firms to assess whether their counterparties are behaving themselves.

Oscar Kenessey, head of trading at NNIP, says, “You expect counterparts to be trading in their own best interests – I personally like the challenge that creates as it tests the traders’ skills – but the Code of Conduct has helped to make it clear what is expected of those counterparts.”

Other traders perceive the code to have been ineffective at effecting change in the marketplace.

“It is a good thing but doesn’t go nearly far enough,” notes the global head of trading at a Tier 1 asset manager, on condition of anonymity. “I don’t think it had any impact at all on how we trade. We have not changed the way we trade as a result of the Code of Conduct.”

With the burden of proof for best execution still very much at the feet of investment traders, and healthy scepticism that counterparty behaviour will be changed for the better by regulators, it is the buyside trading desk where the battle for best execution must be fought.

This involves a good understanding of transaction cost analysis (TCA), with data from post-trade analytics fed into pre-trade tools in order to better support trade execution decisions.

“I come from a systematic background, so I lean towards quantitative analysis,” says Chambers. “I would always recommend clients not to take too anecdotal an approach towards informing trading decisions. Really you want to make sure you are producing a feedback loop. You need to understand from a quantitative point of view what is going on, then with the quantitative results have that interaction and dialogue with the opposite side; LPs with the buyside and vice versa.”

Phil Weisberg, EVP of strategic planning and partnerships oneZero, adds, “If you can help traders create a positive feedback loop between the data that is generated by trading activities and how they use that data to make real-time decisions about pricing and risk, and put that together for them, it gives them the ability to take two or three steps ahead in terms of upgrading their technology infrastructure.”

Trading desk evolution
Building more effective trading is contingent on the right level of technology investment within the buyside, to support better trading across multi-dealer platforms and for bilateral trading based on direct streaming of currency pair prices.

“Pain is around workflow, and how to minimise inefficiency,” says Hugh Whelan, head of EBS Direct & head EBS Institutional at CME Group. “Every firm has its own unique approach to its mandate, best execution and how to manage broker restrictions. After that, the priority is usability within the platform. We have developed screen-based trading and application programming interface (API)-based trading, and typically having fewer clicks per action is important – how can I, as a trader, get to execute with the most amount of information and fewer clicks, and without having to navigate multiple screens?”

To take advantage of those facilities, which could allow smaller trades to be automated and thus freeing up traders’ time to manage more complex trades, investment managers need the right technology on their trading desks.

“The biggest focus is on the active management buyside, where there is a lot of attention on automation,” says Whelan. “As a fully automated execution management system, we are at the forefront of that technology evolution with our First Derivatives platform which is highly efficient, very fast and manages workflow very well.”

If buyside traders are to take full advantage of streamed prices from the sellside, and to engage more fully with both swaps and listed derivatives trading, their trading teams will need to have the systems in place to build trading analytics in their workflow, including post-trade data, along with an understanding of collateral costs at the point of execution.

“We’re finding on the buyside the first and foremost desire is for stability,” Whelan says. “There is also a desire to be modular, so clients can pick and choose around their core back office systems, which means they would like to choose the execution management system (EMS) they use separately from the order management system (OMS) to complement it, and so they don’t have to buy a full front-to-back solution.”

If change does not materialise on the buyside desk then either dealers – or multi-dealer trading platforms – may need to adapt instead.

“The sellside is finding the economics of the existing market structure around electronic execution extremely challenging,” says Coalition-Greenwich’s Jacques. “I expect some changes in market structure in the coming years. There are a number of possible evolutions to this market. It is in everyone’s interest to have a healthy market and all participants are keen to work towards this goal. We are already seeing platforms respond with things like all-you-can-eat pricing.”

©BestExecution 2021
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