FX execution algos (EA) may help support price discovery and market functioning but they also have the potential to create new risks, according to a new report from the Bank for International Settlements.
Algos are currently used for an estimated 10%-20% of daily global spot FX trading. Regulatory demands to minimise costs and improve transparency have spurred the growth of algos in the $6.6 trillion-a-day FX market, where trading is fragmented across dozens of different platforms.
Canvassing 70 market participants globally, the report found that while EAs improve market functioning, they als:0transfer execution risk from dealers to end users as well as contribute to changing liquidity dynamics and the underlying market structure.
The report said that there is evidence that FX algos add to thinner order books as they slice orders and spread them over time, which has reduced the need to provide large amounts of liquidity. “With less large limit orders to buffer market shocks, a thinner order book leads to a lower ability of the market to absorb shocks in periods of stress from news or ‘fat finger’ trades.” it added.
However, it also notes that as the “order book is often replenished quickly, market functioning as a result of thinner order books is not as heavily impacted. Although in the long-term and under certain market conditions, price discovery could be hindered.”
Overall, the report found that FX EAs are beneficial to market participants in terms of navigating the fractured landscape, with most providers surveyed providing access to more than 10 liquidity pools via their algo trading services. They can route orders to the best available source of liquidity making them an effective tool to help match diverse trading interests.
As Hugh Whelan, global head of liquidity management at EBS, notes, “This study clearly shows that when it comes to the use of algos in FX, the benefits far outweigh the concerns. Fundamentally, algos are enabling the end-user be it active trader or portfolio manager to deliver better execution for clients.
Take the example of a portfolio manager devising their month end hedging strategies ahead of the US election this week. That asset manager, is faced with having to make trading decisions in the midst of elevated volatility making the cost of adding hedges potentially quite expensive.
Depending on how large major currency market swings and how long uncertainty and volatility lasts, a portfolio manager will need all the tools at his disposal to source the best liquidity and execute efficiently. In this scenario, the use of algos has become very popular and allowing the end-user to manage the situation far more efficiently than a human trader possibly could.”
©BestExecution 2020
[divider_to_top]
