The Last Look…
Posted by Colin Lambert. Last updated: August 17, 2021
It was suggested to me last week that the growth in outsourced trading in equity markets will inevitably spill over into FX and become a similar growth story there, especially as firms look even more at cross-asset execution desks and services.
That’s all well and good, and it has to be said that if an asset management firm is giving up control of its execution in a major asset class like equities or fixed income, then it might as well do the same in FX, where it views the trade as part of its administration, rather than alpha seeking processes. Once again, however, this idea conveniently ignores the differences in market structure, and I am struggling to really understand how such a model thrives in foreign exchange.
I will not make this about the Fix, but it is a good example – even though orders through this mechanism are not viewed as agency – because all too often the execution quality at a Fix is poor. Yes, it provides an independent benchmark, but how it is achieved rarely reflects the best outcome for reasons I have discussed many times before.
I do not, for one minute, believe that people executing orders on behalf of others are conscience-free. There is a school of thought that the agency model – and that is what outsourced trading is of course, the same animal in a different coat – means the executing party don’t care if the trade goes wrong, but that is a good way to go out of business early, and no-one really wants that.
That said, there is a decent argument that states an agency model can be very formulaic, and fail to react to changing market conditions – hence why banks are focusing so heavily on the so-called “reactive” algos. This type of execution is fine in a market where everything is regulated and all trading takes place on a limited number of venues all offering the same market access. It’s easy to track and, apart from that significant minority who prefer to execute in dark pools, market impact is seen as a fact of life.
Things are different, however, in FX markets – where significant slippage does not have to be part and parcel of doing business. In an outsourced FX model a large number of trades would have to be executed as an aggressor (market impact) and if bids and offers are posted to an ECN using third-party credit there would be information leakage.
Aha, I hear some of you say, what about using some of the single dealer venues to post bids and offers? There is merit in that argument, and an outsourced trading desk with connections to all the major single dealers could offer value, but how robust would it be? For all the niceties that are often spouted about collaboration and mutual benefits, the fact is an outsourced trading desk is actually a competitor to the major dealers. Who is giving this flow to the agency/outsourced desk? Firms like asset managers, who are often firmly in the focus of the major dealers.
If you want an example of how this works, look at the last industry to spring up as a competitor to the major dealers – the multi-dealer platforms. Yes, they have proven to be valuable businesses for their owners, but in the spot FX D2C space specifically, how many continue to grow strongly? With the exception of FXSpotStream and Integral – both of which offer a different type of trading relationship, no-one else who publishes regular volume data is above where they were three years ago. Why? Because the banks understand that they are a competitor to their own single dealer platforms and while they are obviously willing to compete for customer business on those venues, they’re nowhere near one of their major revenue channels.
Agency has been tried in FX and it didn’t gain traction – I struggle to see how giving the model a new name will change matters.
Some banks are embracing the agency model of course, although pointedly few are willing to describe their business model using that tag, through their algo business – but as a friend and I agreed last week in conversation, using an algo is a very interesting approach because the customer pays to keep the market risk!
Where outsourced trading might work is if it breaks one of the unwritten rules of the game and is more interactive with how they execute – if they use an algo for example, make it one they can interact with and change the parameters of to demonstrate their skill and knowledge. The problem is an agency/outsourced execution desk has a specific job to do and there is little or no room for flexibility – if it goes right does anyone really notice, if it goes wrong the roof falls in. That is not a risk/reward scenario designed to encourage an imaginative approach!
In an OTC market, the best way to execute is to tap into a genuinely deep and diverse liquidity pool and that means the major dealers and their internalisation models and, in some places, their internal ECN/exchanges. The key is finding matching flow away from the public market, and while that is achievable by outsourced trading desks, the reality is these pools of liquidity exist in maybe half a dozen dealers at most. Why pay an extra fee and give up all control just to access pool(s) of liquidity everyone knows are the best?
Firms argue, with merit again, that the cost of maintaining an execution desk is too high and that outsourced trading represents a more economic option. That’s fair, but as an investor, I think I’d like every stage of my investment process to be managed effectively and by the firm that I am paying my fees too. They can argue the fees will be higher if they don’t get rid of the execution desk, but in reality – as is always the case in a fee-based business model – competition means any increased cost will be short-lived.
It can be argued that by using risk transfer, these funds are outsourcing their FX anyway, but I think that a specious argument – they are managing their risk in what they believe to be the most effective manner. More pertinently, they are the ones making the decision and therefore an investor knows who is accountable – the more a service is outsourced, the further those executing become from accountability.
In markets where there is little or no room for imagination when it comes to execution – such as equities – I can see the value of an outsourced model, the job the agent does is unlikely to be that different to anyone else. In a market like FX, however, the different market structure means a major dealer often offers an advantage, but like accountability that advantage is diluted the more “hands” the liquidity goes through.
Underpinning all of this is another huge factor – the dealers’ willingness to assume risk in trickier conditions. Some dealers will offer access to great liquidity, but in reality they are still only agents because their access to internal and private liquidity is very limited.
I cannot repeat it enough, the best way to execute without slippage is to do so without information leakage and signalling. It seems to me that in FX at least, that approach is extremely difficult for an outsourced desk. Agency has been tried in FX and it didn’t gain traction – I struggle to see how giving the model a new name will change matters.