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December 2, 2013

Taking a Closer Look

Wary of competing algorithms, some heads of foreign-exchange trading desks are rethinking their high-frequency trading practices.

By By Mary Schroeder

While not 100 percent certain his problems come from high-frequency trading, Mike O'Brien is suspicious.

Eaton Vance, the Boston-based investment management firm where O'Brien is head of global trading, started using foreign-exchange algos four or five years ago. At the time, Credit Suisse's AES platform was the dominant player. "They have a very good product and well-designed algos," O'Brien said. However, he's not as happy with FX algos as he once was.

Algos can work well when Eaton Vance is trading a stable currency that's not moving around a lot while the firm is trying to trade closer to the midpoint, O'Brien said. Algos are also useful in trying to get large trades done when the firm doesn't want to show its hand to the market, he added.

But lately O'Brien has become concerned that the algos are having a market impact. The trading formulas don't seem to be as effective as they were a few years ago, and "the market moves against us far more than it should in a random environment," he said.

And O'Brien is seeing this issue with the algos of a number of investment firms. "I'm fearful that there may be algos in the market looking for this type of flow," he said.

Eaton Vance is currently trying to identify what is and is not working, looking at executions by strategy, currency pair and time of day.

The investment manager is not alone with its suspicions. A sharp rise in the use of high-frequency trading strategies in the foreign-exchange market is causing consternation among money managers and brokers, and trading venue operators are taking steps to calm their fears.

Slightly more than 40 percent of trading volume in spot FX is currently represented by high-frequency trading, up from 3 percent a decade ago, according to Aite Group. Popular trading venues include Currenex and Hotspot FX and electronic interdealer broking platforms EBS and Reuters. Activity is most prevalent in the major currency pairs.

This year, two interdealer trading venues have implemented processes to mitigate the impact of HFTs. EBS, a unit of interdealer broker ICAP, has taken steps to address the concern about a race to zero, which motivates trading firms to invest inordinately in reducing latency.

EBS recently implemented initial steps to curb high-speed trading by eliminating any speed advantage one party might have over another in the race to rank high up in the queue.

Under the move, messages transmitting orders for the Australian dollar/U.S. dollar currency pair-the fifth most liquid-are bundled into batches and run through a process that randomizes their report in the queue, a report from Reuters said. As a result, the first message to hit the system won't necessarily be the first order processed. The speed of the randomization process is between one and three milliseconds, Reuters reported.

EBS has been hammered in the past two years by declining volume. Analysts at Aite Group attribute part of the drop to general business conditions, but also maintain that the "dissatisfaction of some of its primary bank liquidity providers at disruptive behaviors" at EBS are to blame. EBS is the oldest of the interdealer platforms, but it's no longer the largest. A 30 percent drop in volume last year caused it to lose that position to Thomson Reuters.