The Last Look…

Have we become too obsessed with best execution? More pertinently, are we even looking in the right direction when judging it? It’s a strange question I find myself asking, but too many people that I speak to, seem, to me at least, to be looking at the wrong metrics.

The problem may be that we have taken a quantum leap in a relatively short space of time when it comes to best ex, from just a few short years ago when so many paid lip service to the concept, to now, when so many analyse for the tenth of a tick improvement. This is not to say a tenth of a tick isn’t important, on sizeable trades it most certainly is, but more to ask, is the tenth of a tick improvement being analysed in the right environment?

Talking to people on the buy side (and as I shall note later, this is a very broad and varied community), I find it strange that a good number still don’t think about market impact and information leakage – in FX at least. A decent-sized group does the work on those two aspects of best execution, but too many are laser-focused on hitting top-of-book, which, as we all know, is not necessarily the best way to go about things, especially if there are a few hundred trades coming along behind! It’s the essence of ‘tick-box’ TCA.

I was chatting to someone in the hedge fund space about this last week, who was keen to blame fragmentation in FX venues, the simple logic being – as the CIA used to say – ‘a secret shared is a secret squared’, and there is something in this. The top LPs, with strong internalisation programmes, are spread across many venues, but on many they share the environment with firms simply looking to make a quick turn – and the PB’s name doesn’t give anywhere near enough anonymity. Hit the ‘wrong’ LP and quality denegrstes – even though you are still hitting top-of-book.

It is interesting that the buy side seems to be making more noise about the use of their data, as noted by the GFXC after its last meeting, but my conversant last week thought some were making a rod for their own back by insisting on sweeping, even if it is – and this surely is an oxymoron – ‘passive or gentle sweeping’. There is no doubt that the more public the venue on which the buy side trades, the more chance there is of their trade, and by association data, getting into, if not the public domain, then certainly the pricing of multiple LPs.

Someone else I spoke to last week also thought that the increased use of algos was a factor – namely while the user of the algo is concerned with market impact, they have little control over it. Some strategies only trade on internal venues, which is fine, but a great number externalise, and even if it is a small percentage of the parent order, it will still make a splash. Algo providers work extremely hard to protect order information, but the minute one piece leaves the virtual walls of the institution, that protection starts to break down.

Different players want, and measure, different outcomes…we need to introduce more sophistication into the debate – yes, a tenth of a tick is important, but for some it isn’t, or should not be, the be-all-and-end-all

So, too many seem to be looking at the individual price(s) they are hitting and not considering the onward effect of their trade. In truth, this is nothing new for many on the buy side, we should perhaps be grateful that they are starting to catch up with their more professional peers who were onto this years ago!

Talking to someone else on the buy side about this, their suggestion was that the algo providers themselves are not helping, mainly thanks to their strenuous efforts to differentiate in a crowded market. This view was that there are two types of providers, just as there are two different types of LPs, which is something of a follow on from this column two weeks ago. The first group stress internalisation and are in a highly competitive space and as such, emphasise their ability to get an extra tenth as it is a differentiator. This is fine, my friend observed, but it can sometimes lead to a degree of impatience and a rush to hit the top-of-book, rather than wait. (I naturally observed that while there are some really good algos out there, too many are still jazzed-up TWAPs!)

The second group is what my friend termed the pure agency model, where a lot of the flow is externalised, mainly because the provider is, to all intents and purposes, a broker. Here, they argued, there is clear information leakage, and while I find myself agreeing, I cannot help but think about Credit Suisse’s AES, which, back in the day, was very popular in FX, thus, one assumes, successful at minimising impact?

One other complicating factor in this is the diverse nature of the buy side – best execution means different things to different players. A hedge fund that trades aggressively with multiple LPs, for example, has a much different view from an asset manager trying to ease a large sum into the market. To the former, a bit of market impact may not even be a bad thing, while to the latter (or many of them, I have to insert my contractually-obligated whinge about the Fix here), it is anathema.

The role of fragmentation is an interesting one, because my understanding is that while some big players on the buy side have introduced a second platform to their tech stack, few go beyond that. They also are careful with the type of algo they use (but again, the Fix is a dumb TWAP, so it’s by no means universal). This means that fragmentation can only have an effect if their LPs are exiting the risk across multiple venues – back to internalisation!

I am as guilty as any in my habit of talking about the buy side and best execution in very generic terms, because the clear fact is it is anything but generic – different players want, and measure, different outcomes. So, we probably need to introduce more sophistication into the debate – yes, a tenth of a tick is important, but for some it isn’t, or should not be, the be-all-and-end-all.

To answer the question at the top, we probably are a little too obsessed with best execution, but it’s not as simple as that, because it means different things to different players. Perhaps what we should be obsessing about with asset managers is different to that with hedge funds?

Personally, and looking across the entire buy side, I would have one word of advice on this – and it is deliberately generic and paraphrases the old saying about liquidity: You will always get best execution when you’re wrong!

colin@thefullfx.com