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...Algorithms are Migrating to Currencies
Securities Industry News, October 23, 2006
Last month, the investment banking subsidiary of Bank of America Corp. announced the pilot of its first algorithmic trading strategy for the foreign exchange market, with expanded access to liquidity on third-party platforms. BofA also added several enhancements to its Foreign Exchange Electronic Trading Services (ETS), including live options execution, improved pricing and risk management. Soon ETS will include a TWAP (trade-weighted average price) algorithm, also now being piloted, that the firm says will deliver an average execution price and minimize market impact.
These are familiar echoes from the world of cash equities, where highly computerized, programmatic and algorithmic trading approaches have become a dominant market force. They are among the strongest indications to date that algorithms also have a place in the $2 trillion-plus global foreign exchange market, both contributing to and feeding off of its accelerating transaction automation at a time when investors are incorporating FX into multi-asset-class strategies.
Technology-savvy brokerages are scrambling to stake out leadership positions, and BofA is prominent among them. "We think we have a very good suite of equity algorithms and are a leader in that space," Scott Freeman, head of FX ETS at Banc of America Securities, said in an interview with Securities Industry News. "Now we're trying to leverage that expertise and knowledge to be a leader in the FX space."
Also in late September, Barclays Capital launched algorithmic forex trading on its Barclays Automated Real-Time Execution (Barx) system. Its Barx PowerFill provides "much-valued transparency into the market [and] further demonstrates our commitment to optimizing our clients' FX trading experience," said Ivan Ritossa, head of foreign exchange at Barclays Capital, the investment banking arm of London-based Barclays. Behind Barx--Barclays' multi-asset-class e-commerce platform--Barclays Capital's large FX trading operation employs algorithms to determine execution styles while minimizing hedging costs, the company said.
Another FX algorithm, Timeslice, was announced a month ago by Citigroup technology subsidiary Lava Trading. Traders can use it to break orders into smaller lots and thus minimize market impact.
Experts on foreign exchange trading and technology note that algorithms are still at an early stage relative to the equities markets, where e-trading took hold first in large part because of the presence of well-developed exchanges and direct-market access capabilities. Forex is a decentralized, dealer-driven market that is now benefiting from efforts to consolidate and streamline trading through front-end automation and through single-dealer and multidealer platforms or ventures that resemble electronic communications networks in stocks. One of the more ambitious centralization efforts, with a clearing component included, is FXMarketSpace, which the Chicago Mercantile Exchange and Reuters Group plan to launch in 2007.
Market participants have long recognized that established equity trading techniques such as baskets and order slicing apply to FX, and "as with any trading style, you try to extend it," Glenn Stevens, managing director of forex technology specialist Gain Capital in Bedminster, N.J., said in a recent interview. "A lot of algorithm providers are getting [FX-related] inquiries," he continued. One holdup has been that in the absence of centralized platforms, "partnerships are important," and therefore had to be formed.
Gain Capital CEO Mark Galant added: "Funds are comfortable with algorithmic trading from their experience in the equity markets, executing block trades using algorithms like VWAP [volume-weighted average price]. They are quickly finding out that in the fast-moving FX markets, algorithmic trading is even more effective."
It stands to reason that as the market grows, along with automation, algorithms and other programmatic techniques are certain to follow. Amid that expansion, "the biggest challenge facing people in the FX market is the stability and scalability of systems to handle the order flow," said Octavio Marenzi, CEO of Boston-based research firm Celent. "People who traditionally didn't participate actively in the FX markets have been drawn in."
Technology Support
Gain Capital, Lava Trading, Portware and Integral Development Corp.--which has entered into a strategic alliance with Barclays Capital to white-label its technology for others--are among the system suppliers helping to fuel eFX, or electronic foreign exchange, trading, and are finding that algorithms are increasingly in demand. Penson Financial Services Canada, a unit of Penson Worldwide, recently upgraded its Penson FX system, used by more than 20 brokerages globally, for improved auto-dealing and support for the FIX protocol. The latter capability will better serve algorithmic arbitrage or proprietary trading, which, Penson noted in an August announcement, have become "increasingly popular as more and more market participants rely on computers to automate their trading decisions."
"More and more firms trading FX as an asset class are using some form of algorithmic trading to seek alpha," said Gain's Galant. "Our clients have been using our API [application programming interface] for three years to program their own trading systems. Our API publishes a streaming rate feed, accepts trade requests and publishes electronic confirmations. Clients can completely automate their entries and exits and achieve almost instantaneous execution, from signal to deal confirmation. This type of control is especially valuable in a 24-hour market that can move pretty quickly at times."
Gain is "also working with third-party platforms to allow sophisticated retail traders to employ algorithmic trading," Galant said. "Retail traders are utilizing simplified programming languages or off-the-shelf systems to suit their trading styles." One such partner is NinjaTrader, a Denver-based developer of high-performance trading software.
Lava Trading is moving toward the launch of its LavaFX trading platform later this year. It's billed as providing the interbank community with an impressive array of sophisticated order types, full depth of book and superior eFX functionality. One feature that Lava says has never before been available to the FX market will allow banks to "blindly" shift large positions quickly and quietly among themselves.
Although FX algorithms have yet to mature, LavaFX chief executive David Ogg said that the technology developers are already pushing the envelope of sophistication. "The clever ones are the ones coming out with useful tools, as opposed to just copying what's used elsewhere," he said. "People need to understand what works in FX as opposed to what works in another marketplace and trying to clone it here."
New York-based Portware, a leader in execution management software, has a product dedicated to foreign exchange. "Our general client base is active-trading hedge funds, and the other part of our business is the traditional asset manager," said Andrew Yao, head of Portware FX. "What I think is happening is that these algorithms are targeted at the traditional money manager, and it's a carryover from equities, of course. From our standpoint, our clients have been trading black-box FX, but by writing their own algorithms using our platform."
Barclays' agreement with Mountain View, Calif.-based Integral is aimed at enabling regional banks and brokerages to offer eFX trading functionality to their respective customers. "This product will enable our financial institution clients to offer FX solutions to their own clients, benefiting from the FX technology expertise Barclays Capital has built up over the years," said Ritossa of Barclays Capital. "Combining our innovative market technology with Integral's hosted solution enables our clients to manage their own secure trading environment."
Harpal S. Sandhu, CEO of Integral, added: "From our experience in developing eFX solutions over the last decade, the best outcomes and market-differentiating results come from a close working relationship with leading institutions. We look forward to rolling out a series of technology platforms and enhancements with Barclays Capital over the coming years."
Not Quite Like Equities
Celent's Marenzi said the FX market's trajectory toward algorithms is "somewhat similar" to that of the equities market. "For algorithmic trading to really take off you have to have a reliable electronic execution venue to facilitate it," he said. "What changed was that a new group of market participants came in--hedge funds--as a major driver of growth and the adoption of algorithmic trading."
Stevens, a 25-year FX market veteran who before joining Gain Capital in 2000 was head of North American sales and trading at NatWest Bank, estimated that "65 percent of algorithmic trading benefits in equities" apply to forex. In a structural sense, noted Portware's Yao, equities trades "are done for commission--you can send an order to a bank or broker and they're paying a commission. In the FX world, things get done and you pay the spread."
Another major difference, said LavaFX's Ogg, is that "algorithms are best suited for liquid instruments. There are thousands of those in equities, and in FX there is a limited number of currencies."
Mark Warms, general manager for Europe of New York-based trading portal FXall, said that about a dozen currency pairs comprise 85 percent to 90 percent of the FX volumes traded. "What you find is that because there is so much liquidity in these few instruments, there are a number of very large providers, especially banks, that are natural market makers in those currencies," he said. "Imagine you had an equity market where there are 12 stocks you are trading. It might look very different."
Fixed Income Next?
The fixed-income market may be the next to get the algo treatment. It's happening more slowly than foreign exchange, "but the bets are that it will in the future," said Marenzi. "There's a different structure to the FX market in terms of how it functions and operates. ... You tend to find algorithmic trading taking off fastest where there is an order-driven environment and greater price transparency."
"These markets generally all follow a similar path," said BofA's Freeman. "We think FX is a few years behind equities, and some of the fixed-income markets are a few years behind FX. There are similarities among all of the markets, but it's not clear to us yet whether or not they behave sufficiently and in a similar way where algorithms would develop in those other asset classes. At the end of the day, it's the clients who drive the demand and innovation. So if clients need to more efficiently execute trades in the market, we think we have the unique brainpower to help them solve those problems."
FXall's Warms said the use of algorithms will vary, depending on the specific market. "Even in FX currencies, I think the jury is still out," he said. "There's a limited number of hedge funds or banks participating, and I think we will see an uptake in participants using algorithmic trading models to make prices."
"It's not quite there yet," Yao said of fixed income. "We're ready for it [because] we built our platform to be multi-asset, so it doesn't matter what the security is that you're trading."
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