March 2011 / 15 March 2011 / FX-MM
The FX market has evolved electronically by embracing change and being fast to adapt to the changing requirements of both new entrants and established players. While once the OTC FX market was seemingly always playing catch-up with the equities and derivatives market in terms of processing and trading technology, the need to create standardised processes for non-standardised contracts traded across a diverse, and at times fragmented, marketplace has meant that the FX market has leap-frogged with other asset classes and taken the lead in developing next generation trading tools.
Harrell Smith, Head of Product Strategy at Portware, says that the hedge funds, particularly quantitative hedge funds, were among the earliest adopters of Portware technology, and as they continue to engage in the more complex high frequency trading strategies, they still lead the way. He says: “Portware’s liquidity aggregation technology allowed quant funds to efficiently trade against a consolidated book of streaming quotes from all banks, ECNs and interdealer platforms. Combining this aggregation technology with Portware’s powerful and flexible event-based trading engine gave hedge funds a true algorithmic trading solution.”
Smith adds that large traditional asset managers have become interested in advanced trading systems as well. While they are attracted to Portware’s liquidity aggregation and support for numerous order types and strategies, one of the biggest draws of the Portware platform is the extent to which it integrates with their internal workflow applications and compliance rules.
He says: “As asset managers take greater control over their FX order flow, execution is only half the battle. The internal account structures of traditional asset managers tend to be quite complex, as are the compliance rules that govern how traders can execute orders. As a result, it is critical that trading systems be flexible enough to integrate with all downstream workflows and internal compliance logic.”
Order management technology is equally important in both absorbing and executing order flow. For the sell side, trading technology helps firms aggregate and manage client order flow coming into the banks and brokers, in the same way traditional buy side firms manage order on behalf of different asset management accounts. “Similar technology is used to manage orders from internal and external customers and execute those orders efficiently,” says Smith.
Portware currently connects to more than twenty broker dealer liquidity providers as well as five ECNs and interdealer platforms. Smith says: “Traders using a single dealer portal have access to just one source of liquidity. Because Portware is agnostic with respect to liquidity providers, it allows traders to choose how they interact with the market.”
INNOVATION IN THE FUTURE
He believes that the next round of innovation will stem from the dealers when it comes to execution algorithms and Portware has been working with the leading FX dealers on integrating their FX algorithms into Portware. These FX algorithms are relatively new and traditional asset managers are very interested in using this technology. Says Smith: “FX dealers are aggressively developing and marketing their FX algorithms. Because we are broker-neutral, we can take all these different strategies and integrate them into Portware, giving our clients a lot of flexibility in terms of where they send order flow as well as the algorithms they employ.”
Hedge funds too, will continue to innovate and continue to look for ways to drive alpha using advanced trading technology, but for Smith, the most interesting recent development has been the strong interest in Portware’s trading technology from traditional asset managers. “The asset management community has traditionally looked at FX execution as less important in terms of execution quality. However, this is changing fast, as evidenced by CalPERS lawsuit against State Street and recent news surrounding BlackRock and FX trading by its custodian banks. These and other firms are looking closely at the costs involved in managing FX risk and are taking much greater control over the entire trading process,” he says.
So too are traders looking more closely at new technological advances for order management. Fully supporting front-to-back office processing, TwoFour FX, provider of global real-time FX, treasury cash management, limit monitoring and order management solutions, supports spot, forward, non-deliverable forwards, swaps, futures, OTC options (vanilla and exotic) and exchanged listed options transactions for all currency pairs while managing their positions and P&L in real-time.
For FX, TwoFour leverages Microsoft technology, using tools like C# and Silverlite for the management of data and orders to execution and post-trading processing of both market and limit order, regardless of the volume – and supporting up to millions of trades being done daily.
Chris Davis, Co-founder and Global Head of Sales at TwoFour, says: “Once a trader understands what trades they want to execute they want to be able to go out to multiple trading venues, both single and multi-bank portals, to see where the best price for execution is. Right now, some are still doing this manually.”
Later this year, TwoFour will unveil tools to automate the entire process by capturing the order the flow, handling the execution, and processing the trade in the back office.
Whatever direction the debate about the future of FX goes – whether it should become exchange-traded or remain an OTC product – Davis says the firm will support both types of products and adapt its software to support them.
The debate is further complicated because of the forward component to spot FX, depending on which direction cash is being traded, added to the settlement risk contained in CLS and other tools, there is still an element of forward interest rate risk on all FX products. As yet, there is still not full clarity on the regulatory treatment of FX forward and swaps.
CROSS-ASSET: THE WAY FORWARD?
But apart from the outcome of regulation, and whether FX moves towards being an exchange traded product, FX is already mimicking equities in the way that algorithms are increasingly being used to enable smarter order routing to a more fragmented marketplace. If FX was going to be traded similarly to equities and derivatives, would this be the final full push towards a truly cross-asset platform?
Davis says that it is still an evolving market and while the search for the common technology platform is still on, he believes that the winners in the future will always be a best of breed solution. He says: “Each primary asset class – fixed income, equities and FX – all have a derivatives component, whether they are exchange-traded or OTC products. For example, for FX and cash, currency futures are traded on derivatives exchanges, such as the Chicago Mercantile Exchange. Most vendors and platforms have tended to grow from supporting a specific asset class and for this reason I think the market is geared towards a best of breed solution.”
But for Sébastien Jaouen, Head of Trading Community Services at Orange Business Services – Trading Solutions, recent years have shown a greater tendency for a distinct convergence of the FX and equities markets and, similar to equities, latency is becoming an increasingly critical issue in the FX markets. He says: “Among the new electronic trading platforms for FX being provided by brokers, latency is becoming an issue and one that is the main focus for clients and the different financial players we are working with. Already we can see that some firms are making the most of using low latency and high-speed black boxes to arbitrage the FX markets.”
Getting access to electronic platforms is a clear focus for all our clients, whether they are funds or brokers. The way in which you connect to and gain access to these platforms is crucial.”
GETTING PORTALS RIGHT
Using the latest technology, Orange Business Services – Trading Solutions has designed its extranet to enable customers to reach trading destinations as fast as possible, with the shortest route guaranteed, by offering “layertwo technology”. “When a firm wants to connect to a portal, we will actually engrave the route into our network. We don’t let our network decide which route to take – it is pre-defined. This enables us to give, and monitor, the guarantee of the latency in any round trip,” says Jaouen.
With the growing interest and demand for these portals, globally, Orange Business Services – Trading Solutions is working hand in hand with the venues, not only to ensure the right architecture is in place to connect to them, but to optimise the speed of the connection and lower the latency. A redundant route is also built so that clients can switch immediately if service with the primary route is interrupted.
“The more the markets are becoming electronic, the more our clients are becoming dependent on the connectivity to these platforms,” he adds.
Jaouen believes there is great interest from the market in benefiting from mutualised access to FX platforms, or colocation of applications, similar to exchangetraded market to enable firms to leverage on the architecture and control costs. “FX is still very much a broker-driven market, and despite the growth of crossing networks, owned by brokers, and ECNs in Europe, there is still a big difference between this and other markets. The exchanges are much bigger than the FX portals that exist and implementing hosting, or co-location, requires the right model and demand.”
He says: “I understand the drive for the exchanges to set co-location services for their members and white labelling is a new business line for them and good for the industry. However, it only works well where the trading firm trades on one market, but if you are trading on multiple markets what is the value of having your trading infrastructure in one place? In this instance, a third party enables trading on all venues, for equities, derivatives and FX, with the same service levels, and external providers can bring neutrality.” G
oing forward, he adds that tomorrow’s FX trading technology will take co-location to new levels simply due to the fact that the sheer volume of business going through FX portals dwarfs the exchange business.
For Jaouen, the complexity of the fragmented FX market means that specialist services will become more in demand due to the logistics needed to maintain and upgrade these connections, and work that is not core to investment firms, whereas a managed service takes care of all connections and infrastructure. “The extranet can provide one single point of access to all FX brokers and portals,” he says. “We have points of presence all around the globe and connect to the different venues and portals required by our 2000+ companies on the network.”
TRANSPARENCY AND STANDARDISATION
But Gordon McDermid, Director at IT consultancy Sapient Global Markets, says that although the FX market has traditionally been considered as different to the other asset classes, this is set to change. “Specifically, with Dodd-Frank and changes to MiFID, there are a lot of question marks around the cash and OTC FX markets, and how they will be regulated and structured going forward,” he says.
“There is very likely to be a lot more conformity with FX and other asset classes in terms of clearing, initially for FX options and then possibly for swaps and forwards, as recommended by the G20.”
While LCH.Clearnet will launch a clearing solution for FX options at the end of the year, McDermid points to the fact that Singapore, which although is not a G20 country, looks as though it may lead the way in clearing for FX products, in that it is closest to launch this year. Similarly, Hong Kong has indicated that there is a business need for a central counterparty (CCP) for FX.
In terms of trading in the future, according to McDermid, the regulators are pushing trading to be more transparent and to make OTC products more standardised, either on exchange or through trading platforms such as Swap Execution Facilities (SEF) and Multilateral Trading Facilities (MTF). Fixed income and derivatives market provider, TradeWeb, says it is ready to become one of the first to register as an SEF.
“How SEFs and MTFs are plumbed into the trading infrastructure and downstream to the service providers, via technology, remains to be seen but it is likely that there will be trading facilities at the top of the process and trade repositories at the bottom, with CCPs to clear,” he says.
Going forward, McDermid says there is a great deal of change going on and there are going to be a lot of business opportunities to harness technology, or have that change forced upon you. The number of new clearing players coming to market, a market previously dominated by the clearing houses, bears this out.
“Although at this point there is not a great deal of a push for cross-asset class trading, the simple fact that there are more and more players coming to market means that there will be more activity in this space, and more change to come.”
He refers to the increasing interest, both from buy-side and sell-side, in cross-asset collateral and margining. “If there are to be more cleared products, which will bring in other asset classes, such as FX and OTC derivatives, interoperability and a push for cross-margining efficiencies from cross-asset platforms is the next logical step. Unless these exchanges or front-end platforms and back-end CCPs talk to each other, the same players are going to find they are putting up huge amounts of margins at a number of different services.”
For he says, while there is bi-lateral collateralisation available now, with an increasing number of service providers coming to market, there will be more demand that they talk to each and become interoperable. “And where money – and margins – are involved things tend to happen a bit quicker.”
FX HANGS IN THE REGULATORY BALANCE
There is little doubt that change is coming for the FX market but how it will pan out remains to be seen this summer when the US Treasury outlines its final take on the Dodd-Frank Act. Currently the bill provides that foreign exchange swaps and forwards will be considered to be swaps, and subject to CFTC jurisdiction, unless the US Treasury makes a written determination that they should not be regulated as swaps and are not structured to evade the bill.
However, while the CFTC will have jurisdiction over retail FX transactions, even if the US Treasury rules to exclude foreign exchange swaps and forwards, the bill still requires that users are subject to certain business conduct standards, and requires swaps and forwards are reported to a swap data repository or, if this is not possible, then to the CFTC. The technical requirements for reporting to regulators and repositories as well as compliance, let alone clearing, means that this is a space to watch and one that will demand innovation to bring with it the trading tools for the next round of growth.