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The use of execution algorithms in the FX market has increased significantly over recent years and it would appear that this trend is set to continue for the foreseeable future. Under the MiFID II European directive , best execution requirements mandate firms to take all sufficient steps to obtain the best possible result for their clients, taking into account a variety of factors.
Algos can offer tangible value to the best execution process, other than simply delivering the requisite time stamping and transparency required by regulations.
Algos present clear benefits and can help contribute to achieving best execution in some circumstances, but they are no panacea. There are potential pitfalls to be aware of when using them:. However, a product that might appear relatively expensive in terms of headline cost, might on average deliver far superior execution performance when taking into account market impact and other factors. Poorly designed algos or sub-optimal selection and management of liquidity sources may create significant market impact, compounded by allowing other participants to further identify the algo behavior through the signaling risk it has created.
Understanding exactly what any given product does, and how it does it, can be challenging. For algos that access multiple liquidity sources, there can be overheads monitoring which providers are delivering high quality liquidity and superior execution, through, for example, low reject rates and rigorous enforcement of participant behavior. Given the bewildering array of products now available, the process of how to select a specific algo, for the trade in question, becomes complex.
With the increased focus on FX execution from asset owners, trustees, compliance and regulators, it is more important nowadays to be able to record and justify such selection decisions.
The systematic use of best execution analytics, on both a pre- and post-trade basis, can help mitigate the risks associated with algo use, and allow users to make more informed decisions. Find out more by reading Trading in Waves of Change, a special edition of Thomson Reuters Exchange for trading professionals.
Using independent and rigorous post-trade transaction cost analysis TCA can help measure performance of algos across providers on a consistent basis, net of fees. For example, is it worth paying a potentially high fee to use a specific algo, or does the performance over time more than compensate for the fee?
Click here to find out more about how BestX can help you achieve and demonstrate best execution in your FX transactions. There are many other factors to consider when taking steps to deliver best execution, including measuring market impact, assessing price benchmark performance and, for algos specifically, analyzing potential information leakage via measurement of signaling risk. The BestX Best Execution Analytics measures a wide range of best execution metrics for algo trades, as illustrated in the screenshot below.
Another common issue is deciding which algo to use and when, taking into account the trade size, currency pair, desired trading objective, time of day, etc. A number of factors need to be incorporated within the selection process, including whether there is an execution benchmark to consider, or other execution objectives.
Even with certain standard types of algos, such as a TWAP, choosing between different providers can be tricky. A rigorous process, informed by independent pre-trade analytics, and based on objective performance measurement, provides the foundations for such a selection process.
Algos have a potential role to play in any modern FX execution process, helping provide efficient, transparent execution in a cost effective manner. It is imperative that upon embarking with the use of algos that the potential pitfalls are understood and they are used judiciously and when appropriate to the trading objectives, benchmarks and liquidity conditions.
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