While the growth in electronic trading has
stimulated the application of algorithmic trading, it has lead to
some abuses of the term as well as the scale and mode of its
application, more so perhaps in the context of foreign exchange
trading as in any other asset class. In part, this may be explained
because the buy-side institutions and proprietary trading groups
increasingly demand the ability to develop and customise complex
trading strategies in place of off the shelf algorithms. They
require the ability to access not just multiple markets, but to
trade across asset classes, through a range of applications.
Under the Microscope : What holds the key to mainstream adoption of Algorithmic FX
Bob McDowallSenior European Analyst, Tower Group
Bob McDowall discusses the themes of buy-side growth, technology
challenges and reducing market resistance that may provide the key
to mainstream adoption of Algorithmic trading in FX markets.
This article covers three themes, which are the key to mainstream
adoption of algorithmic trading in FX markets:
1) Reducing market resistance and objections to algorithmic
trading? How much resistance there actually is, and the extent to
which objections are substantial or emotional, is a matter of
2) Buy-side growth. The buy-side including, according to some
observers, corporate treasuries are perceived by many to be the
major driver behind the growth of algorithmic trading in financial
markets generally and specifically in the foreign exchange market.
3) The technology challenges. It is only through the successful
development and deployment of technology software and the
facilities which support it that algorithmic trading capabilities
may be exploited fully and profitably.
Reducing FX market resistance and
objections to algorithmic trading?
FX: a suitable asset class for algorithmic trading? Foreign
exchange is a commodity not a financial instrument, unless it is
specifically packaged as such.
Foreign exchange is traded outside an exchange environment on an
Over the Counter (OTC), basis and is probably the worlds largest
OTC market with an unquantified and, perhaps, unquantifiable number
of markets. It is traded mainly on a proprietary basis.
Foreign exchange has too many tradable permutations for the
application of algorithmic trading rules, unless the objective is
to trade a single block of currency to a single value date ? which,
incidentally, may well be the case where the currency risk on a
financial instrument is concerned. Most money mangers have far more
complex requirements. Do these attributes make it unsuitable for
widespread exploitation by application of algorithmic trading
techniques and technology? Personally, the author does not believe
these attributes make fx unsuitable for algorithmic trading.
International banking consolidation over the past decade has
resulted in about 60% of FX by traded value being concentrated in
10-12 banks. They control liquidity and the price at which
liquidity is available.
The roles of voice and electronic trading
Much of the perceived market resistance or objection seems to
derive from the debate about the merits of voice versus electronic
trading. This is a perennial debate, and (in my view) an
increasingly tedious one, about the merits of each. As electronic
communications networks (ECNs) have developed, they have
undoubtedly drawn away business from the voice market. Yet there
will continue to be a role for the voice business in providing
market advice, handling negotiated transactions, working complex
and sensitive orders of very high value and providing a description
of markets which data is not yet able to articulate.
(Fear of) more regulation
The foreign exchange market has escaped relatively unscathed from
the regulation, which is applied, to markets in financial
instruments. Algorithmic trading rules enable a concept of best
execution to be applied to foreign exchange transactions and, as a
consequence, may be seen as giving financial regulators the ability
to apply best execution to the foreign exchange markets. It will to
a very limited extent under the Market in Financial Instruments
Directive (MiFID), where foreign exchange forms a component part of
a securities transaction.
A passing phase?
Will the FX market become relaxed about the operation of
algorithmic trading within the market? It is happening already
driven in most part by the buy-side of the business and the hedge
fund industry in particular, principally through cross-asset
investment and trading where foreign exchange transactions form a
component part of transactions. However, it is as yet difficult,
for me at least, to envisage the majority of transaction flow being
governed by the application of algorithmic trading rules.
Scale of adoption
The author has been unable to find any meaningful figures about the
scale of volume or value of transactions executed using algorithmic
rules in the foreign exchange market. In part, because it is an OTC
market. Furthermore, the majority of such transactions are
components of transactions involving other asset classes.
There is a common perception that deployment of algorithmic trading
capabilities reduces the requirements and cost for expensive
trading desk personnel as well as increasing operational
efficiency, increasing the transparency and the speed of trade
execution. The management of financial institutions where it is
deployed senses that it will enable them to gain better insight and
control over the art of trading and be better equipped to confront
sharp volatility. This may, up to a point, be correct in equities
markets but can the same statement be made about the foreign
The costs of purchase of the technology capabilities for
algorithmic trading or their in-house development capabilities have
to be carefully evaluated. The costs are substantial. It was
estimated that over US$320 million was expended globally on
providing the technology components of algorithmic trading. Even
higher figures are estimated for 2006. Unless the development of
algorithmic trading capabilities is confined to the introduction of
relatively simple algorithmic capabilities, it is very unlikely to
be a one-off investment requiring some periodic minor enhancement.
Rather it is likely to be a continuous investment in developing new
and increasingly complex algorithmic technology capabilities based
on incessant patterns and correlation derived from constant
analysis and comparison of new and historic data. To justify such
investment, the technology driving the algorithmic trading has to
be a unique and direct contributor to the trading revenues,
therefore highly proprietary; certainly unlikely to be bought in
from a software provider.
Mainstream asset management
Recent research indicated that the end of 2005 conducted almost 30%
of US equities trading using algorithmic trading technology. How
much is from the hedge fund industry is a matter of conjecture. The
volume of foreign exchange executed through algorithmic trading
applications is almost certainly substantially smaller in both
value and transaction terms, even though reliable figures are not
available. The US fund management industry continues to be a more
ready adopter of technology than the mainstream, European fund
management industry, in part because the fund management industry
is larger they have a central trading desk for transaction
execution. By contrast, in Europe the majority of fund managers and
certainly the smaller fund managers handle execution of their own
Cross-asset investment and
Undoubtedly, there is an increase in cross-asset investment where
foreign exchange transactions are but one component of the
transaction. It is in the aspect of foreign exchange trading where
the application of algorithmic trading rules to transactions is
likely to increase in proportion to th
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