Complex but rewarding extracting the maximum value from FX Liquidity Aggregation

Transcription

1 LIQUIDITY MANAGEMENT extracting the maximum value from FX Liquidity Aggregation Nicholas Pratt examines how FX participants are able to extract the maximum value from the ever evolving world of the FX liquidity aggregation and how the providers are working to match the demands of buy and sell side. The quality of liquidity, as opposed to just liquidity for liquidity s sake, is becoming increasingly important for FX trading firms. To this end FX aggregation is of vital assistance to both sell-side and buy-side firms. For the former it helps them to effectively compete for client order flow and handle increased trade volumes. And for the latter, it can intelligently source the most suitable liquidity for a varying range of participants. However, to reach this point, whereby traders and banks can extract the maximum value from these tools and tap into high quality liquidity, FX aggregation has had to evolve. The questions is whether the various aggregation offerings, and there are many, have evolved enough. Technology has become more accessible and this has helped to increase the functionality and performance of aggregation platforms. But not every issue in the FX world is solely technology-based. The level of transparency employed by different providers can vary as can the bias towards sell or buy side. Aggregation is increasingly a matching exercise between liquidity providers and trading firms but how exactly is the requisite balance struck? Given that there are only a handful of dominant liquidity providers but no end of divergent liquidity takers of different sizes, is it not only natural that aggregators should lean toward the dominant protagonists in the FX trading world? How can fairness be guaranteed and liquidity takers be assured that the liquidity they see is not only unique and actionable, it is also showing at the best possible price as received by the aggregator? Can best practice guidelines be imposed on the aggregation market? Will regulators insist on the adoption of these principles? Or is the only way to improve the quality of practice, dependent on the actions of the customers and insistence that such principles are a critical part of their selection process when considering a liquidity aggregation provider? CHOICE OF PROVIDER According to Olivier Virzi, COO of Switzerland-based Olfa Trade, the key factors in trading firms choice of aggregation provider are quality of execution, cost and the quality of service. The service we are talking about implies genuine business engineering in order to embrace the business best practices. Some of our clients have to comply with very strict regulations. Providing their buy-side clients with the best prices is one of them. Nonetheless, says Virzi, these buyside benefits must be aligned with the liquidity providers expectations. The liquidity providers are always offering more targeted flows and we have to find the equilibrium between their interests, those of the trading firms and their clients. To achieve that, we help the trading firms offer their client the best available prices within their clients segment and make sure the liquidity providers interests are respected as well. One way that aggregation services are evolving is through different service models, notably the development of managed or hosted services as opposed to off-theshelf platforms. So whereas the technology dilemma for firms used 80 october 2014 e-forex october 2014 e-forex 81

2 to be whether to buy or to build, it is now whether to buy off the shelf or rent from a host. At Olfa Trade we clearly favour hosted and managed solutions as, to us, this is the only way to fulfill the always more demanding buy and sell side clients, says Virzi On the one hand we have sell side clients issuing execution rules which you must respect in order to preserve the relationship between themselves and their liquidity providers. On the other hand we have buy side clients expecting pesonalised tools and streams complying with their very own trading habits. Firms going with an off-the-shelf solution will have to deal with that on their own and will have to consider their IT as an investment cost rather than an operational cost. The second sign of evolution is the offering of advanced features aimed at complying with both traders and liquidity providers requirements. We define with sell side firms, on a personalised bilateral manner, how their prices are used, says Virzi. and we also work with buy side firms how to get the best prices along with guaranteeing the quality of execution. As a result, brokers working on this type of advanced aggregation technology are able to attract buy side customers willing to trade tickets of a size that would only have been traded on a RFQ basis before. The liquidity providers are always offering more targeted flows and we have to find the equilibrium between their interests, those of the trading firms and their clients. other criteria mentioned may find that they do not need to join the race to the bottom on spreads. Every player will have a different understanding of quality of liquidity, says Vincent. To cater for this diversity, smarttrade s system measures rejections by venue/ liquidity provider, currency pair, size of trade and age of quote. We also release all underlying trade data so that clients can mine the data for other potential correlations themselves. Releasing the underlying data allows clients to build real-time reports and to code algos to make use of the data to improve execution experience for both proprietary and client execution. FX Aggregation can also assist sell-side firms to more effectively compete for client order flow and Olivier Virzi improve their ability to handle increased trade volumes, says Vincent. Firms that are purely repackaging rates (auto-hedgers) rely very heavily on the tighter spreads and good depth of market TraderTools FX trading platform More clarity, more transparency... more Alpha. Fully-hosted, SaaS FX... Liquidity Aggregation Pricing Engine White-Labelling Order Management ONLY at TraderTools. QUALITY OF LIQUIDITY There are many ways for FX trading firms to compete says David Vincent, CEO and co-founder of smarttrade. These comprise prices (spread compression), service, depth, reputation, other FX instruments, cross selling of other asset classes & services, trading protocols offered, range of currencies and last but not least, quality of liquidity. Clients that are able to offer quality of execution as well as some of the Your job as an aggregator is to keep both sides happy, it is a balancing act. s "FX Week Europe" London Nov october 2014 e-forex sales@tradertools.com Web:

3 Firms that are purely repackaging rates (auto-hedgers) rely very heavily on the tighter spreads and good depth of market that aggregation brings. David Vincent that aggregation brings. Likewise, firms that take on client risk still need to have the most accurate reference pricing and ability to clear down trades quickly and at low cost when required. to work large flows in the market on multiple exchanges or direct bank feeds. Agency desk may wish to analyse execution quality using our out-of-the-box reporting module and adjust liquidity providers used for execution based on the criteria of the trade itself. Banks want the ability to selectively co-mingle internal traders orders and client orders in segregated pools of liquidity which can be selectively exposed out at liquidity as part of an internalization strategy as well as the ability to move the aggregation engine between multiple trading centres or indeed to have multiple centre engines competing with each other. The liquidity mirage is one of the unwelcome by-products of the electronic age At smarttrade we find that regardless of client type, the ability to customise all of these aspects via open an intuitive GUI and flexible APIs in real-time is the key to leveraging the power of aggregation and making sure its usefulness is maximised for each market segment, says Vincent. Selecting a provider is obviously more than a simple question of picking the right product, says Vincent. Not only do technology providers have to offer top quality out-of-the-box capabilities, but they also have to offer the possibility to customise where needed to differentiate from competition. Usually, the track record of a vendor is good information too. Trading firms need a partner that understands the whole life cycle of the trading activity, from the incoming order to the final trade. Beyond these basic requirements, sell-side firms will really leverage the power of their solution through flexibility and use of, for instance, custom execution algos, multiple liquidity provider streams and liquidity pools, execution analysis but also dual exposure of orders to handle big volumes in the most efficient way, he adds. Flexibility and openness of a solution is what enables the different players in the FX market to get the best out of their aggregation engine, says Vincent. For example, retail clients want an execution engine that can be customised in real-time to move clients between different liquidity pools per currency pair. Buy side firms like the ability to implement custom execution algos 84 october 2014 e-forex

4 The growing popularity of packaged solutions is a trend that seems to make sense in a world of aggregation where the central premise is to consolidate things in one place. A single solution from a vendor with a proven track record in connectivity, aggregation, OMS, SOR, analytics, crossing, and trading GUIs means that clients can often replace many vendors to reduce the risk and lower their costs, says Vincent. The old multi-vendor model is now unsustainable and too expensive. Hosted or managed aggregation services are also becoming attractive even for tier one banks, says Vincent. This gives advantages in terms of latency as well as reducing the operational cost without compromise on service/ quality. As technology has become more commoditised the need for a specialised in-house team to manage aggregation technology is much less than before. The new areas that trading firms choose to focus their limited resources on are liquidity and execution analysis as well as writing bespoke algos to introduce their IP and market view for execution. UNIQUE LIQUIDITY The increased accessibility of technology has lowered the barriers to entry to prospective aggregation providers creating a much more highly populated market on the supply side. And given the increased importance of the quality of liquidity, this proliferation has led some to question whether it only exacerbates the liquidity mirage and, consequently, there are simply too many aggregators out there. There are so many people aggregating liquidity and many of them are showing the same liquidity. Investors have to realise what liquidity is unique and actionable, says Peter Durkan, CTO at Lucera, a provider of virtualisation infrastructure. Another facet of the FX world that exacerbates the problem of actionable liquidity is the longstanding presence of the notion of last look that grants liquidity providers the option to reject a bid. Investors are looking for confidence in the liquidity they see and the operators of liquidity are trying to solve the problems of the liquidity mirage and the problems of last look by actively managing the liquidity and using the likes of smart order routing to do so, says Durkan. The operators want to tell their clients that their aggregation platform can intelligently deal with liquidity and tailor it to the metrics that the liquidity providers want. They don t want to see sweeping flows or for their orders to rise above a particular number, he states. In order to meet the different objectives of both buy and sell side, aggregation is increasingly becoming a matching exercise, says Durkan. Your job as an aggregator is to keep both sides happy, it is a balancing act. It is a balancing act that also has to cater for an increasingly diverse range of participants, however Durkan believes this diversity can be helpful and therefore aggregators should not necessarily place a limit on the participant types. As an operator you have to try to sort quality liquidity and for that you need a wide collection of connections to those liquidity providers and then match that liquidity to the clients and their needs so it helps to have a wide range of participants. They can say that they have a platform that has a fine grade of control and the ability to provide quality liquidity. That is how the platforms can assist. Lucera is a packaged solution that offers smart order routing and provides a fine grain configuration of liquidity but it also has a distributed infrastructure. It also has virtualisation that allows the platform to be nimble and to scale up and down. It is co-located in New Work, London and Chicago where the majority of FX activity takes place. BETTER PERFORMANCE There are a handful of firms that provide virtualisation and it is still a nascent market, says Durkan. We will see demand continue for aggregation. Better performance will be key and those that cannot provide that will fall by the wayside. You also have to have platforms that are more transparent so that it is possible to see what is going on, especially for the operators so that Peter Durkan There are so many people aggregating liquidity and many of them are showing the same liquidity. Investors have to realise what liquidity is unique and actionable, 86 october 2014 e-forex

5 The idea of best practice guidelines for aggregation providers has been mooted operators to use and understand and make intelligent and informed trading decisions. LIQUIDITY MIRAGE The liquidity mirage is one of the unwelcome by-products of the electronic age and the growth of aggregators has in some ways exacerbated this issue. The liquidity mirage is certainly not helped by the concept of aggregation, says Yaacov Heidingsfeld, chief executive of TraderTools. they can answer questions from clients about certain orders. It is like everything else. The ones that evolve quicker and build a smarter product will succeed. But there are different demands out there from different participants and that creates different providers. Time to market is a big benefit for the users of third party aggregation services, says Durkan, especially new start-ups. If you are setting up an FX agency you need hardware, co-location, a FIX engine and connectivity to liquidity providers. With a packaged aggregation solution you can get all of that out of the way and focus on matching liquidity providers and takers. That s where the money is and the quicker you can get to that point, the better. It also reduces the cost of hiring software engineers and developers and the like. The top firms will always build their own hardware, they operate in a rarefied atmosphere. But for the rest, they just want good software and hardware that someone else can manage. It reduces cost, risk and time to market. The big priority for aggregation though remains the ability to assess the liquidity of quality and ensure any prices shown are both actionable and unique. This leaves aggregators with some decisions to make, one being whether to include ECNs in their aggregation given that the ECNs are themselves aggregators of a sort. There is a struggle with ECNs and aggregation says Durkan. You have to be careful because some of these ECNs are already aggregating and showing liquidity that is not actionable. ECNs are useful but you have to be careful and the onus is on the aggregation platform to make sure that the liquidity is actionable. The idea of best practice guidelines for aggregation providers has been mooted. Durkan says that while all platforms may have proprietary characteristics they are keen to protect, what defines best practice is often dictated by which segment of the diverse FX market the provider is operating in. It is about being smart about how you operate and publish orders so that is easy for First of all there is a limited number of banks that are primary liquidity providers in FX and they are the ones that will be aggregated. Their technology clearly has limitations in terms of dealing with this mirage. The banks are happy to stream a price on their single dealer platform (SDP) as well as a number of aggregators and their intention is to limit the prices to a subset of that aggregation. But if they are streaming prices on their own platform and even just one aggregator, that limit is already being breached. Added to this are some macro issues, says Heidingsfeld. Firstly the investigations into the abuse of fixing mean that banks have taken a step back form market making and risk taking. Secondly, volatility is at an historical low. So now we have a situation where banks are operating on an agency basis rather than a principal basis. And once you are doing that, then two venues distributing the same price is too many. The issue of avoiding recycled liquidity becomes further complicated by the presence of ECNs which themselves aggregate the prices of several banks. Consequently some providers, such as TraderTools, choose not to aggregate ECN liquidity. It is not a technology issue but ensuring that the ECN is not aggregating 88 october 2014 e-forex

6 the same liquidity that we are, says Heidingsfeld. Our job as liquidity aggregators has become more sophisticated and we have become better at matching unique streams of liquidity. It is relationship liquidity using one to one pricing. There are no gold silver and bronze tiers of liquidity based on traders creditworthiness. It is an internal marketplace. The key principle that is fundamental to any aggregation service is that, despite the advancement of technology, FX is a relationship-based business says Heidingsfeld. What the technology has done is create a level playing field. Liquidity providers are presenting their business in a light where takers can fairly compete for that price. I think we make it fair. Liquidity providers can compete to go after the customers they want because they are not all competing for every pair. We aim to empower both sides. Nor does TraderTools allow last look. Last look was created as a way to solve a technology issue that had created a business problem the fact that high speed traders could possibly game banks quotes. But it is no longer an issue because technology has reduced the legacy lag. Ultimately, says Heidingsfeld, these decisions are for providers to make for themselves rather than be mandated by regulation. The market will determine whether they want last look or not by voting with their feet. BEST PRACTICE GUIDELINES Some liquidity providers such as EBS have attempted to provide best practice guidelines which have received some commitment from aggregators but nothing like a unilateral acceptance, says Heidingsfeld. As long as aggregators can win business, they will get away with avoiding best practice guidelines. So I think it s As long as aggregators can win business, they will get away with avoiding best practice guidelines. So I think it s doubtful that we ll ever get to the point where everyone follows the rules. doubtful that we ll ever get to the point where everyone follows the rules. And I doubt the regulators will pursue this issue because they have bigger concerns. But if everyone does not embrace best practice, that is to our advantage. It is also questionable whether a single set of guidelines can be imposed on a market as divergent as FX. While it may come down to the discretion of aggregators as to whether they include ECNs or provide last look, there are some principles that should be nonnegotiable, says Heidingsfeld. The prices made available to traders have to be unchanged and not with an additional spread on top of the original prices. Aggregators should not be providing an unfair advantage to one liquidity provider because of commercial agreements. If you are, then be transparent about it. The price that the aggregator is getting is the price that it should be showing. It should not be making money on the spread at the expense of the price. In a model where we are acting in a truly relationship-based aggregator, that transparency is inherent. It is really incumbent on the aggregators to engender best practice, says Heidingsfeld. If we re offering technology as a service, it is up to us to educate our clients. It is our fault if they don t know what the benefit of best practice is. One customer told us that the reason they don t trade on a single SDP or a single aggregator is that they do not get enough liquidity. We explained the liquidity mirage and that they were paying for it by receiving worse spreads. In fact, they were being Yaacov Heidingsfeld penalised by the liquidity providers and ended up taking more risk. We said we would talk to each of their SDPs in order to prove that this client was not trading on multiple venues. In return, they got better spreads. The imposition of a best practice standard is indeed problematic and its adoption by aggregators will be best helped by the insistence of their buy-side clients. If they insist on best practice, greater transparency and all that comes with that, lo and behold, a new transparent environment will most likely emerge. The problem in the FX market, perhaps more than any other, is that it is credit-driven. And while service providers and sellside firms will listen to those clients with bountiful credit limits, they may not be quite so receptive to those at the lower end of the credit scale. And it is these smaller firms that are unlikely to have their demands accommodated and are more likely to be treated less fairly by the aggregators acting on the more unscrupulous side of the market. 90 october 2014 e-forex