Forex Trading Getting ‘Equitized’

How Forex Trading Is Going Electronic

Foreign exchange and equities are two distinct asset classes, each with their own set of trading procedures, customer demands and levels of execution.

But that is not stopping trading desks at the nation’s largest asset management firms from nudging the two closer together. Often at the behest of clients, asset managers are coming to the realization that trading in these seemingly disparate types of financial instruments needs to be at least synchronized, if not also overseen by the same trading desk.

“It’s really a radical transformation of FX as an asset class,” said Will Geyer, head of order and execution management systems at ITG, an agency-only broker. “It’s a natural trend and points to the sophistication of the FX process and the desire to bring the thought leadership in equities to the growing FX operations.”

The reasoning behind this push, several trading firm executives told Traders, is to better harmonize equities and FX trading. Working the two in concert offers the best of equities trading-transparency, low-cost and rapid-fire electronic execution-in the firm’s currency trading operations.

In effect, asset managers are starting to “equitize” the FX side of the trading ledger. This means creating an FX trading operation that comes to mimic equities trading with competing electronic trading platforms that offer low transaction costs, high speed and greater transparency.

In practice, algorithms designed for currency trades can scan for the best price and execute instantaneously in quantities determined by a trade schedule. The algorithms bring the promise of lower costs and efficiency to the end user, Geyer noted.

This is already true in FX trades done in tandem with equity side transactions that involve foreign securities, according to Mark Kuzminskas, director of trading at Robeco Investment Management. For example, if you have a customer trading in Japanese securities, chances are they’re going to be sitting with a serious position in yen, to back up that trading. Those buyside firms want to manage that exposure on the FX side, and lock in profits on a trade at the best possible exchange rate. “Lots of investors are playing with the FX part of the trade that way,” he said.

The move is also an overt attempt, the executives added, to bring the best practices of equity trading-such as algorithmic trading, superior order flow and execution via ECNs, as well as a focus on transaction-cost analysis-to the FX side of the business.

In the most concrete examples, some of the largest investment managers have made their heads of regional equity desks take on the additional role of heading the firms’ FX desks. Vanguard Group, the largest mutual fund firm, has had its equities trading desk chief handling FX desk duties for the past few years, said Vanguard spokesman David Hoffman.

“We agree FX is starting to develop like the equity market,” Hoffman said. Vanguard, for instance, has made it a priority to use transaction-cost analysis to guide clients’ trading and routing strategies, with the goal of matching a client’s objectives with a particular trading style. “That said, on which desk the trading is actually done is not that important.”

The movement toward better equity-like execution on the FX side makes a lot of sense, said James J. Angel, a visiting capital markets professor at the University of Pennsylvania’s Wharton School. “The rest of the securities universe is going to get equitized,” Angel said. “All the innovations that we’ve seen in the equities market are going to spill over to the rest of the asset world, both domestically and internationally.”

Algorithmic Growth

Algorithmic trading, which currently represents just about 5 percent of FX trading, is one area where an equities-style execution could greatly improve the FX trading paradigm, Geyer maintains.

Given the low level of algorithmic trading on the FX side, there is enormous room for growth if FX traders strive to emulate their equity counterparts, where more than 50 percent of equities trading is now done through algorithms, according to data from industry research firm Tabb Group.

“The trend could optimize the life cycle of execution by using the guidance of the equity side,” Geyer noted, adding that this “life cycle” includes the process in which the trade data is captured, analyzed and implemented as a set of trade strategies. The cycle is repeated to tweak and optimize the end results.

Increased use of electronic platforms is a natural fit for FX, said Robeco’s Kuzminskas. “It makes tremendous sense from the point of centralizing the whole trade relationship,” he told Traders Magazine.

Indeed, while executives such as Geyer and Kuzminskas theorize that this push is being led by customers seeking more equity- and FX-linked trading strategies, there is another factor involved: regulatory change that is encouraging more transparent and modernized trading platforms.

This changing landscape in terms of the growing modernization and multiplatform electronic trading is being quickly ushered in by new regulations, such as Regulation NMS. The National Market System rules established in 2007 by the Securities and Exchange Commission were intended to “modernize and strengthen” the nation’s equity markets, Angel said.

“It’s a Reg NMS world now,” he said. But a full embrace of algorithmically driven execution of trades in non-equities asset classes such as foreign exchange will not happen overnight, mostly because of regulations governing differing asset classes.

“But because FX is so easy to monitor, every buyside investor who is not doing [transaction-cost analysis] on its FX strategy runs the risk of being found negligent,” Angel said. “There is an FX component on almost every trade, and asset management firms have to be careful that they are treating that with the same care as they are the equity trade itself.”

Special FX

Many of the largest asset management firms, such as Fidelity Investments, BlackRock, Vanguard Group, State Street Global Advisors, JP Morgan Asset Management and others, acknowledge that in certain circumstances, customers’ FX trades need to be handled in tandem with their equities trades and that those trades have taken on increased importance.

Many of the firms have taken steps within the past year or so to better synchronize trading in the two asset classes, even moving some personnel around to give FX the benefit of increased equity trading oversight.

Fidelity Investments also has recognized the synergies between the electronic markets in equities and FX, according to spokeswoman Sophie Launay, and has moved to structure the two trading operations similarly.

Obstacles to the increasing linking and automation of trading equities and FX exist. These mostly come from the largest global banks, such as Deutsche Bank, J.P. Morgan or Barclays, which would see their strongly entrenched positions as foreign-exchange trading titans displaced under a dispersed and fully automated FX trading environment.

The situation is similar to that of the New York Stock Exchange market makers in the 1990s, who didn’t want to give up their turf either and were in no hurry to be displaced by electronic exchanges such as the Nasdaq Stock Market, said Angel.

There, those electronic participants-such as Knight Capital Group-who were able to understand the changing market and embrace the new technology were able to adapt and flourish. “Frankly, FX pricing is an easy thing to do and an easy thing to monitor,” Angel explained. “And large investors are realizing that the banks may not be giving them the best pricing.”

Indeed, State Street and BNY Mellon are currently defending their FX trading fees in court against accusations from several state pension funds that the banks promised low-cost FX trading, and then inflated their profits with hidden markups. Both banks have said the pension funds’ claims are without merit.

State Street’s own exchange-traded fund and investment management operation, State Street Global Advisors, agrees that entrenched interests may slow full synchronization of equities and FX, unless such melding of trading operations is mandated by regulators, like the SEC.

“However, I think the SEC has other things on its plate right now,” State Street spokeswoman Alicia Curran said. “But I think most traders would like to see it happen.”

At State Street, there are three regional heads of equities, in the U.S., Asia-Pacific and Europe. Each head oversees all asset class trading, including FX, and all act under the firm’s global head of trading, Chris Rice.

While State Street Global Advisors, trading is still a smaller operation (fewer than 100 traders), it is moving toward common platforms, something Curran said is an industry goal.

Separately, State Street eExchange, which is part of State Street Global Markets, a brokerage division, also created two electronic FX trading platforms, FXConnect, for limited institutional use, and Currenex for retail use, Curran said. 

“Everybody would like to see FX get more electronic execution, but sometimes, you just have to pick up the phone and call J.P. Morgan because the electronic volume is not there,” Curran said.

 

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