Nothing drives the buyside to adopt transaction-cost analysis faster than perceived malfeasance by their sellside brokers and dealers. When Bloomberg published its June 2013 story on the U.K.’s Financial Conduct Authority’s investigation into alleged collusion by traders from the largest foreign-exchange dealers to fix the WM/Reuters 4 p.m. benchmark rate, it could have created a spike in interest in FX TCA.
“Since local regulators in Asia, Europe and North America are conducting their own investigations, it has given buyside clients an incentive to analyze how their FX trades are executed. They’re questioning whether they received best execution, which could be partially measured by FX TCA,” said Howard Tai, a senior analyst at industry research firm Aite Group.
One would assume the buyside would have more FX TCA on their minds due to the current market investigation, said Evangelos Maniatopoulos, head of global Advanced Execution Services’ FX trading and FX products at Credit Suisse. “We speak to our customers about TCA on a daily basis, and we can certainly say that there is a significant focus on the topic from the buyside community. Perhaps this is also driven by current market investigations, ” Maniatopoulos said.
The initial spike in interest actually first appeared in the second half of 2009, when the California Public Employees’ Retirement System and the California State Teachers’ Retirement System sued their custodian, State Street, for overcharging the pension funds on standard instruction FX trades. Other custodians like Bank of New York Mellon also found themselves subject to similar suits brought by other pension funds.
“The perceived wisdom was that the foreign-exchange markets were efficient and cheaply priced,” explained James McGeehan, co-founder and CEO of FX TCA consultancy FX Transparency. “For most investors, price discovery mechanisms and oversight processes are the case as trades can be done efficiently in the OTC market, but for many after the California litigation came out there was weakness that people had not recognized and not uncovered. It spurred the need to look at currency execution since it trades over-the-counter. Banks and custodians are not acting as fiduciary; they’re acting as principal, which makes them economically opposed to their client on every trade.”
According to a recent Aite Group white paper written by Tai, “FX Transaction Cost Analysis: The Buy Side Weighs In,” the buyside trading desk was the prime consumer of FX TCA. After them, the portfolio managers and the compliance staff were just beginning to delve into best-execution policies.
FX Transparency, which opened its doors in the spring of 2009, has seen interest from every type of buyside market participant, such as pension funds, pension fund clients, asset managers and asset owners, according to McGeehan.
“The adoption of TCA in FX trading, however, is still in the early stages, but we have seen an accelerated uptake since late 2010,” says Tai. “The use of TCA in equities has been around for more around two decades, but it really has not been done in earnest until a decade ago, when asset owners began demanding proof of best execution, which drove the asset managers to demand equities TCA offerings from service providers, brokers and others.”
FX IS NOT EQUITIES
Although analysts have been using TCA in the cash equities and other listed securities markets, applying it to the fragmented over-the-counter FX market brings a separate set of challenges.
“There’s no counterpart of the U.S. equities market’s national best bid and offer, consolidated market data feeds or standard benchmarks in FX,” said Credit Suisse’s Maniatopoulos. “The FX market has been and remains largely a risk maker and risk taker’s domain. Comprehensive transaction-cost reporting is difficult to achieve when simply measuring a counterpart’s performance versus a bespoke risk price.”
“Without any central time and sales reporting platform for the FX market, any FX TCA study will have a handicap where one has to define a reasonable market environment and an appropriate executable venue for the trade’s currency pair and size,” added Aite Group’s Tai.
It is possible to implement popular TCA models, such as implementation shortfall, even though a trade or portion of its child trades might be executed on an order-driven or quote-driven venues, “but most firms do not have all of the necessary data to measure it accurately,” said FX Transparency’s McGeehan.
Without publicly listed volume metrics to which to refer, other performance metrics like volume-weighted average price (VWAP) are difficult to calculate, he added. “There is plenty of data available, but you need the expertise to understand the risk profile of the trade from the available market data.”
Sourcing the appropriate market data used to generate an aggregated bid-offer spread that acts as an execution benchmark is not for the faint of heart. FX Transparency pulls in data from approximately 10 different sources to calculate the midpoint of its benchmark bid-offer spread.
“Our contracts with the data providers prevent us from identify the individual sources, but we source data from interbank dealing systems, voice brokers quotes, FX ECNs and other places,” McGeehan said. “The only thing we are missing is the actual trading volumes.”
The most difficult historical data to obtain is from individual dealers that deliver it over the telephone or via their single-dealer platforms, since it is a closed loop of prices, according to Tai. “There are very few buyside firms that have the IT budget and sophistication to store, retrieve and analyze that data for FX TCA. There’s probably only a handful of firms that are capable of doing that at this moment.”
Yet, without that data, any performance calculations, will be skewed since the voice-broker market is where the FX market truly exists, McGeehan said.
THE NEXT GENERATION
As FX traders continue to adopt electronic FX trading and its associated use of trading algorithms and direct-market-access capabilities, the resulting execution data will let analysts dissect execution quality even further. “Earlier forms of TCA didn’t have this sort of benefit, since they could be executed over the phone without a proper time stamp,” said Tai. “These trades could be recorded merely as part of the post-trade confirmation and settle process like a message received from one’s custodian. When a client receives this information from its custodian or third-party FX broker, it makes it difficult for the client to retrace the order’s step for proper baseline comparison.”
Tai sees this increased availability of electronic execution data feeding a new segment of TCA in FX that examines best execution. Dubbed quality-of-execution analysis, or QEA, it examines an FX trade’s execution price as well as the state of the market before a trade is entered, the execution method used, where the order is sent, how it is executed, how long it takes for an order to be completed and how each fill performs during that period, as well as the overall performance of the trading strategy used.
If it sounds as QEA is drawing FX TCA analysis closer to TCA measurements used in the equities markets, it shouldn’t be surprising, said Victor Lin, a director in the trading strategy group at Credit Suisse AES. “There are different issues in gathering data for FX compared to equities, but the general concepts are similar-for example, grouping trades based on factors like size and aggressiveness.”
When Credit Suisse AES introduced its FX TCA offering in 2007, it relied heavily on lessons learned with its equities TCA product. “If you look at Credit Suisse’s equities and FX TCA offerings, they are purposely similar in design-often, the people looking at execution quality are looking across multiple asset classes,” said Lin.
The broker’s original FX TCA offering simulated the moment when a client theoretically clicked the trade-execution price and compared that to the average price a client would receive at the end of the trade.
“We now look at what happens before and after the trade-the spread capture, the reversion, top-of-book spreads, depth-of-book liquidity, as well as interval TWAP, interval VWAP-and look at how the market reacted at the beginning of a trade versus at the end of the trade,” Maniatopoulos said.
Credit Suisse AES delivers these results in various custom reports and visualization tools, “which brings patterns to life and helps clients understand the multiple drivers for a trade’s cost like trends, order size, liquidity, trading strategy aggressiveness and underlying volatility,” he added.
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