On the regulatory front, a handful of new policies are set to affect the options market and will likely enhance transparency, execution, and market data. Meanwhile, the cash equities business has hit a level of maturity and we are now trending toward better tools for block crossing and less resource intensive methods of trading.
“The most valuable commodity I know of is information” – to quote Gordon Gekko from the 1987 movie classic Wall Street. This line has never been more significant than in today’s data-fuelled financial markets, where detailed analysis of information can provide that all important competitive edge – both now and in the future. To achieve this, firms are looking towards Transaction Cost Analysis (TCA), which enables them to reduce costs and hone trading strategies.
This isn’t new. TCA has been established in equities for many years and while compliance was initially the main driver, it has increasingly proven to add alpha to the execution process. As a result, it’s not surprising that the TCA focus is now spreading beyond equities, with foreign exchange (FX) trading trading now coming into the spotlight.
It is not simply a case of applying the equities model to FX, however. The idiosyncrasies and inherently complex structure of currency markets have presented challenges to TCA’s progress in FX. Added to this is the fact that FX has often been outsourced to third parties, or may be a secondary or subsidiary trade linked to another asset. So not only has accurate TCA for FX trading proved more demanding than in equities, but the impetus has not been there in the same way.
However, times are changing, and recent events emphasize the need for smarter use of TCA in FX. As shown in ITG’s recent report on tradable data between London and New York before and after the 4pm fix, the costs from the order arrival time until trade execution are on average 17 basis points, 20 percent of the time. This is crucial as 17 basis points of implementation shortfall for up to 20 percent of all days can potentially cost asset managers millions of dollars of value lost from their funds. Not an insignificant amount for any investor.
With greater scrutiny on the role and efficiency of the 4pm London fix, the time has come for the asset management community to take full advantage of the data available to inform their execution strategies. Forward-thinking investors are already beginning to position FX TCA as a critical business function, enabling better trading outcomes and enhancing performance. Last month’s data can be a significant input to this month’s decisions on when and how to trade, maximizing the benefit from their FX trading. This takes on even greater significance when you consider the percentage of the collective pension funds which directly or indirectly participate in the currency markets. Even incremental improvements must be pursued.
To make these improvements, asset managers need to squeeze the very most out of all the information at their disposal. For this to happen, TCA providers need to anticipate what an asset manager might require from their data analysis in the future. A combination of growing regulatory pressure and a need for higher returns is triggering clients to demand even better execution. This will see them asking more testing questions above and beyond the standard analysis.
New technologies are also driving new trading strategies in FX, resulting in a need for further analysis on topics such as algorithm selection and the use of trading venues. Such granular analysis sits alongside the broader questions of investment process such as the most effective time of day to trade a given currency pair, the optimal frequency of book squaring, or the decision on when to use an Electronic Crossing Network (ECN) rather than calling a bank on the phone.
The key to unlocking future success is for the TCA provider to work closely with the asset manager ahead of execution. This enables both the provider and the asset manager to get a better understanding of the investor’s objectives and set these against the prevailing market conditions before deciding on its trading strategy. It really is a classic case of using data to support the decision making process. As we move forward, asset managers who achieve competitive advantage will be the ones that adopt this approach in order to evolve their trading strategies in FX, using that “most valuable commodity” – information – to answer the increasingly testing questions for tomorrow, not just the ones for today.
Please find this article referenced in the Wall Street Journal. Responding to many client requests, the FX team at ITG Analytics reviewed trade data surrounding the WM/Reuters London Closing Spot Rate Service (“the fix”). By observing the factors that influence…
Ofir Gefen, Head of Electronic Brokerage at ITG Asia Pacific, looks at how opportunistically taking blocks of liquidity rather than sticking with volume-based trading habits can improve trading performance.
As everyone trading Asia Pacific markets will tell you, managing performance and finding liquidity are significant challenges, particularly in small and mid cap stocks and in emerging markets.
While some of this is inevitable due to macro investment factors and market microstructure, drilling into the detail suggests that this could still be improved by changing one aspect of habitual trading behavior – the use of VWAP or participatory strategies to spread orders based on volume profiles, rather than taking blocks of liquidity when they become available.
VWAP was the dominant benchmark for institutional trading globally for many years, but based on increased use of TCA tools and a focus by fund managers on absolute trading costs and their impact on fund performance there has been a shift to adopt IS (arrival price) benchmarks. In Asia we have seen this particularly over the past five years. IS is now widely seen as a better method to align the trading performance with the overall fund returns.
However, although the use of the IS benchmark has grown, the correlation to adopt IS trading strategies instead of VWAP to actually execute trades has not been 1 to 1. Given low liquidity in many Asian stocks, traders often prefer to stick with the comfort of VWAP or volume-based strategies in one form or another. There is also the concern that getting done at one price too early may result in a bad performance outcome if the price moves in your favour later in the day, so sticking with volume is taken as the risk-averse approach.
Nevertheless, trading with volume using VWAP or a participatory strategy often results in extended completion times, particularly for larger orders, and could harbor a far greater risk that the price will move away from the IS benchmark due to this delay.
In today’s Asia markets there are now liquidity tools that enable traders to get the ‘best of both worlds’: quick completion to minimize delay costs, while still managing market impact. Traders who recognize the problem are increasingly turning to block crossing tools such as POSIT Alert, to find liquidity in size quickly, and at a fixed mid-point price which prevents adverse price drift and higher overall trading costs.
Analysis shows that executing a block in POSIT Alert® is on average 32bps cheaper than the expected impact and spread cost of executing a similar size order of that stock in the market. When applying the analysis to small cap names, the average cost savings rises to over 50 bps; and when analyzing orders executed that are larger than 10% of ADV, we measure an average of 40bps savings.
The key takeaway for traders? If a) you’re benchmarked to IS or b) your goal is to reduce absolute trading costs by getting a result that’s close to your portfolio manager’s decision price, taking advantage of blocks as soon as they become available normally gives you a much better outcome than spreading your order out along a volume horizon. The benefit is even greater for mid and small cap stocks, or orders larger than 10% ADV.
Traders that already realize this are changing their habits – this can be seen in the distribution of the stocks actually crossed (Q4 2013 – Q2 2014) in POSIT Alert. While the lit market typically trades about 60% large caps, 25% mid caps and 15% small caps, and dark aggregation tools get success mostly in large caps, the majority of POSIT Alert blocks are in mid (42%) and small (23%) caps.
Breaking the VWAP habit and having the confidence to take block liquidity at mid-point as soon it’s available, particularly in an illiquid name or larger order size, should help traders manage some of the highest costs associated with the Asia Pacific markets. As investment interest in Asian mid and small caps grows, this will be particularly important in the overall context of fund returns.
Our analysis of Canadian equities order flow this quarter indicate that HFT activity has scaled back slightly: total order flow reduced, Order-to-Trade ratio decreased, Volume Traded-to-Order ratio increased, and the rate of order activity has slowed down. We also add to the debate over the cost of real-time market data – we describe an objective method to intrinsically value market data using three core factors. How much should market data be valued?