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Algos Expand into the World of Long-Term Investors

By ValueWalk
Asset Management

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Algorithms are expanding their reach in the world of trading, a Greenwich Associates report observes. What was at one point the purview of high-frequency traders and systematic CTAs has now moved to the point long-term investors and corporate end-users are using algorithms to execute their FX trades. This is having an impact on markets, with different types of algorithms suiting both a passive and aggressive investment style while European regulators are mandating a best execution standard for trades.

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Algorithms help long-term traders keep FX trade data confidential and deliver best execution

Looking at a survey of 78 buy-side foreign-exchange traders including institutional fund managers, categorized as “real money” due to their long-term economic motivations behind trades, as well as corporate interests, who often have a hedging motivation.

Among this group the trend towards algorithmic-based trade execution is pronounced. From 2015 to 2016, the percentage using algorithmic trading grew from 16% to 21%, for instance; similar corporate usage grew from 7% to 10% with spot FX volume transacted by algorithm rose from 10% to 28%.

Richard Johnson, Vice President at Greenwich’s Market Structure and Technology practice, said these last holdouts, whose use of algorithms had been “limited,” decided they did not want “to be left out of this trading technology arms race.”

“For these traders, algorithms are sophisticated tools that allow them to intelligently access multiple liquidity sources, reduce information leakage and improve trading performance,” the report said, mentioning issues such as reducing information leakage regarding positions that are also used as a logic for trading on dark pools. “The increase in penetration suggests that this segment is primed for growth in algo trading as overall FX volumes rise.”

The fund manager accounts, those trading over $50 billion in notional value per year, increased their algorithmic trading usage from 30% in 2015 to 34% in 2016. Smaller corporates have been growing, but lag behind the larger firms in terms of overall adoption.

Driving the decisions to use algorithms are primarily best execution and pricing concerns, the survey found.  But that same study revealed that day-to-day sales and research also played a relatively large role in making decisions.  Other algo selection criteria were ease of use, reliability and technical support available, desired by 66% of respondents, while liquidity quality towered over execution quality and commission cost, favored by 56%, 41% and 39% respectively.

FX markets have different algorithm types for best execution to meet a given need

While on the surface trading on FX and other markets such as interest rates or commodities might seem like it would be relatively the same. But that is not the case.

The vast foreign exchange markets have operated differently than many derivatives or equity markets. Often times the brokerage firm or exchange takes the opposite side of a trader’s position, as opposed to a middle layer of market maker providing liquidity.

Just like the underlying liquidity and maker-taker structure is different, the algorithm type varies, as FX transactions have their unique execution considerations:

While FX execution algorithms can share the same names as equity algos, the transition from one to the other is anything but cut and paste. For example, a true VWAP algo is not prevalent in FX, due to the lack of consolidated trade-volume data. And given the dearth of dark pools for currencies, there are no “dark” or “stealth” algos. A table of the most popular types of FX algos.

The report reviewed six primary algorithms with one being active. This rationing of algo order types correlated to a degree with the overall goal of the trading algorithim. Most algorithms used by investors in the Greenwich Associates were for passive investing – only 20% were categorized as “aggressive” in nature.

This article was originally published in ValueWalk.

Photo: Ivan T

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