FX Order Management: Let the games begin!
Yaacov HeidingsfeldCOO of TraderTools LLC
Yaacov Heidingsfeld looks at why institutions looking to grow
transaction volumes and profitability should examine the benefits
of a commercially-available FX Global Order Book.
There are two primary factors driving
development and investment in FX Order Management (FXOM): business
process and added value. With regard to business process, banks are
vying to provide more functionality as a means of attracting more
customer business. Automating the process also reduces the sales
and administrative costs of managing that business. In terms of
added value, most banks believe that the information contained in
the order book can be used to better understand individual client
behavior as well as general industry trends. Evidence of this
growing interest can be seen in the proliferation of research in
the area of Microstructure pricing.
Participants in the FX markets, especially the larger banks and
brokerage houses, are now looking to extract value out of order
flow. Many of these organizations have grown through mergers and
acquisitions, and have therefore inherited disparate business
practices and systems resulting in fragmentation of liquidity. Time
differences between their international dealing centers only add to
this fragmentation and loss of centralized control. Therefore such
institutions are now looking for ways to view their order flow
across their organization. Lastly, buy-side institutions are
becoming more demanding, and there is pressure to reduce the
overall cost of trading, clearing and settlement.
In order to support and grow the overall number of clients served,
an institution requires an always-available workflow processing
engine that automates all aspects of the electronic dealing
process. FX transaction costs are at least partially determined by
the difference in the bid/ask spread, corresponding to the loss
incurred by simultaneous Buy and Sell transactions.
The most cost-effective way of executing trades for a market-making
institution, is to cross them internally while still achieving best
execution. [See figure 1 below.] Apart from saving on transaction
fees, internal crossing minimizes the impact and opportunity costs
of trades, while maintaining available credit. Liquidity can also
be enhanced by directing organization-wide order flow into the
internal marketplace, provisioning features like market-making,
auto-quoting from inventory and providing a single order book that
follows the markets across the globe.In order to keep up with market growth, an institution would want
to adopt a flexible, hierarchical, enterprise-wide platform for
managing foreign exchange orders, where the top layer of management
is responsible for the entire inventory of orders; to wit, a Global
Order Book for the enterprise.
Global Order Book requirements
The first requirement for a Global Order Book is for it to be
structured according to hierarchy. Hierarchical order management is a
policy-based system that uses an organizations natural structure in
the shape of a pyramid, with each row of dealing entities linked to
entities directly beneath them. Each unit of the hierarchy must be
able to perform its tasks without any interference from other units
(on parallel, higher or lower levels).
Secondly the Global Order Book requires flexibility. The system must allow for the
widest set of business practices so that each unit within the
hierarchy can tailor the system to how it does business. It must
also allow for changes to processes, requirements and asset-class
support as business needs change.
The third requirement for a Global Order Book is performance. Everyone in the hierarchy
(dealers as well as customers) should be able to receive updates
from the system in real time. The system should have a flexible
security policy that is defined and enforced top-down and includes
the ability to restrict access from one entity to another.
Finally a Global Order Book must have clearly defined points of
integration to front-, middle-and
back-office systems at each level of the hierarchy and have the
ability to interface out-of-the-box
with any system.
The overall goal of a Global Order Book is to grow order flow.
Order flow, in this context, is taken to be a variant of net demand
of buyer-initiated and seller-initiated orders. As noted by Lyons
in his 2001 book, The Microstructure Approach to Exchange
Rates, order flow is a variant of, rather than a synonym for,
net demand because, in equilibrium, order flow does not necessarily
equal zero. More efficient crossing the ability to buy and sell
against two orders while capturing all or part of the spread means
that there is less need for what is commonly known in the FX market
as hot potato trading as a means of sharing risk.
Further, in their paper entitled, Evolutionary Reinforcement
Learning in FX Order Book and Order Flow Analysis, Bates, Dempster
and Romahi examine whether pattern recognition techniques can be
applied to successfully infer trading strategies when order flow
data is coupled with order book derived indicators. Their promising
approach has shown that the use of order flow and order book data
is usually superior to trading on technical signals alone.
What does this mean to the market participants?
Putting theory into practice
As the sell side competes for volume growth, and the buy side
becomes more selective in its processes and more demanding
technologically, we see the FX liquidity providers continuing to
invest in their own order management offerings.
Whereas in the past, the order book was little more than an
electronic notepad with alarms to notify traders that certain
market conditions were now in place causing an order to be executed
it is now becoming the keystone to managing a banks FX business.
Firstly, more and more pipes are being opened into the order book
to enable the seamless entry of orders from sales desks all the way
down the pyramid to the ultimate buy-side customer. These pipes
take the form of APIs (Application Programming Interfaces) which
allow a bank to integrate all order flow from all its various
sources multi-provider portals or the banks own branded Internet
offering. Depending on the business model of the provider bank,
some offer APIs to their buy-side customers to be integrated
directly into the black-box, high-frequency trading models so often
spoken about in todays trading environment.
Other banks offer their customers the ability to send order
spreadsheets in a customer-driven format for automatic upload by
the bank in real time into the order book.
Secondly, once these orders are active, institutions are now
differentiating themselves by offering automated execution. Orders
are now being processed with minimal human interference in a truly
automatic, yet customizable, way. This automation basically
eliminates the need for traditional manual filling, with the
associated costs in terms of time and human resources. Customized
automation using streamed rates can now be provided according to
client and/or institutional preferences based on specific execution
rules. [See figure 2 below.]Figure 2: AutoFill
Thirdly, once the order is executed, the customer is notified
automatically in real time. Here too, various institutions are
trying to differentiate themselves by offering some or all of the
various methods for electronic notification. Some offer a web-based
applet, email or SMS; others offer an API. In the first three
offerings, the customer is basically a passive entity waiting for
notification. In the case of an API, this notification can be
integrated by the buy-side trading engine to generate additional
orders which are then fed via the API back into the order book.
Finally, the effect of the additional information contained in the
order book has some provider banks using this data in order to
shape and create electronic pricing. This information is also being
used to identify the pockets of supply and demand (in the form of
Buy and Sell orders) and in the automated execution environment.
Tier-one banks are currently investing in technology in the area of
FXOM in order to retain their premier positions. The key drivers
(1) Business process, to attract and service customers more cost
2) Added value, from the extraction of order flow information for
more effective pricing
Innovations must include the ability for customers to have direct
access to their order books, and at the same time, reduce
associated transaction costs. To accomplish these goals, larger
banks and brokerages would like to implement a Global Order Book
which optimizes internal order flow in order to capture the spread
on maximum deal flow for increased profit margins and reduced
transaction costs. Furthermore, by integrating FXOM functionality,
instead of having to resort to hot potato trading, smaller
organizations can now compete directly with their larger
The stagnation years for investing in new technology in the Finance
industry seem to have come to an end. Consolidation within the FX
industry has convinced many participants to invest in tools that
focus on FXOM. Institutions can readily license available
technology, customize it with their own brand of added value,
integrate it into their existing infrastructure thereby growing
transaction volumes and increasing profitability all without a
commensurate increase in risk. All institutions aspiring to these
goals should examine the benefits of implementing a
commercially-available FX Global Order Book today.
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