Is Increased Transparency Changing FX Market Behaviour?
One aspect of the growth in fintechs in foreign exchange markets has been the emergence of independent third-party analytics firms providing detailed analysis of, amongst other things, execution quality, but are these firms’ services making a difference?
It can be argued the simple answer is ‘yes’ because more providers and their clients are basing their relationship discussions on data, although it is very difficult to track how, or if, pricing and trading behaviour has changed, and where. That said, anecdotally, The Full FX has been told by several sources that relationship discussions are healthier, mainly because – thanks to third-party providers – both are working with the same set of trusted data.
As noted in these pages, specifically in a recent column on pre-hedging, trust does remain an issue, however, when it comes to execution, this is spite of independent TCA being one of the first areas targeted by the fintech world.
Away from trust, however, which will inevitably take time to rebuild, not to mention the time it can take if firms need to alter their best execution policy, the analysis provided by these firms has enabled the FX industry to better understand what strategies work, and what don’t, amidst constant regime change.
Looking at this, a new paper from BestX takes a look at how its observations on markets have changed over the past two years, finding that certain algo strategies are going out of favour amidst the regime change since the heady – and volatile – days of 2022. One aspect to note is that BestX’ data is based upon the $50 trillion in assets under management and a notional value of over $120 trillion within its “opt-in” pool, which means the data is tilted towards the behaviour of investors and major banks. That said, this also means it captures a huge proportion of the algo-using community.
This is notable, because while the paper confirms the decline in volatility since 2022, it also observes that volumes have also dropped off, but this needs to be tempered with the recent data from the world’s FX committees, that look across the entire market, that indicate turnover is at an all-time high, thanks largely to increased trading between principals.
In its latest paper, BestX observes that the prevailing market conditions are widely held to be due to the high risk-free rate in the US as well as well-performing equity markets, two conditions that together reduce the incentive for cross-border capital flow, and by association, the demand for FX trading.
The market share of different algos in the BestX opt-in database
Source: BestX
This raises an interesting question, however, one that is put in the paper – how does the buy- and sell-side effectively navigate this regime and prosper? “Embracing Darwin’s principle of adaptability is essential,” the paper states. “It is crucial for industry stakeholders to remain abreast of the latest trends and adapt their strategies accordingly to succeed.”
One area that can be adapted is the use of different strategies when executing using an algo. Historically, the basic TWAP and VWAP strategies have been most popular, mostly because, due to the opaque nature of the OTC markets in particular, they are easier to compare and measure across providers. This is changing, however, largely as a result of the emergence of TCA and analytical firms like BestX, who are helping users better understand their use of algo execution strategies. This has led, BestX observes, to the buy-side favouring strategies such as Implementation Shortfall and Arrival Price rather than TWAP and VWAP.
BestX observes these are opportunistic strategies, which generally present lower signalling risk, capture better spreads and, naturally, provide better performance. The paper presents data confirming that opportunistic strategies perform systematically better on risk transfer than other algo styles. “This is a positive narrative, demonstrating that high-performing
algorithm providers are becoming more popular, leading to enhanced outcomes for clients,” BestX states. “This also positions BestX as a leader in steering the industry towards more effective practices.”
Overlaying these benefits, independent providers have also eased the bottleneck caused by less-than-transparent market data. “Traditionally, capturing accurate timestamps was challenging for custodian data, but concerted efforts by BestX and their custodian clients have led to significant improvements,” the paper states. “The standard deviation of the spread has notably decreased over time, evidencing enhanced accuracy in trade timestamp data, which is a key metric of data reliability in financial transactions.”
While the growth of independent providers has undoubtedly had a positive effect on the spot FX market, and more lately NDFs, perhaps the biggest opportunity for these firms – and indeed market participants – lies in the extension of the service to other markets. In FX, the forwards and swaps market stands out as one that will see greater automation, but in STIR products more generally, opportunity is likely to abound.
It remains unclear whether the buy-side will fully embrace algorithmic execution for what are typically large FX swaps trades, where they currently put dealers in competition, but even if they don’t there are opportunities to better understand their business strategy. The BestX paper observes a study published in 2022 by the firm which compared the regulatory impact on different LPs, specifically, the Standardised Approach for Counterparty Credit Risk – SA-CCR – on STIR liquidity.
The spread and standard deviation of custodian trades
Source: BestX
Interestingly, BestX says since that study, the sell-side has become more proactive – other services going live offering novations and compression, as well as the growth of clearing also helped – leading to a more stable forward spread divergence between US and EU banks. In recent years, the latter have had an advantage in STIR markets, mainly because US banks had what could be called “first-mover disadvantage” by coming under SA-CCR ahead of their offshore peers.
Another potential area of growth could also be FX options, where automation is also growing, although here, with the even greater number of inputs into a price, and the very granular detail demanded by many clients may mean it is some way off. Notwithstanding that, when and if this demand is realised, the chances are that those firms in the forefront providing TCA services will be independent.
