FX liquidity is changing, be careful

Published on 3 February 2020

The timing of foreign exchange trades, their market impact and explicit costs must all be considered by asset managers’ trading teams, as they try to optimise investor returns. While banks are reducing their risk appetite, they are showing clients greater transparency on executable prices on-screen, clearing the risk rather than warehousing it.

In a low volatility market, with tight spreads, this level of efficiency is entirely necessary in order to deliver liquidity at a decent price. Increasingly automation can be brought into the buy-side workflow to optimise its use of this liquidity, says David Scilly, head of fixed income and currency dealing at First State Investments, but traders must be aware of the liquidity they are interacting with, and the post-trade analytics they use to assess execution quality.

Dan Barnes Welcome to Trader TV, your insight into trading for professional investors. I’m Dan Barnes. Trading foreign exchange is a crucial part of international investment, but as an adjunct to investing, typically it represents a cost to investors. David Scilly, head of fixed income and currency dealing at First State Investments, is here to discuss how asset managers can employ automation in trading to increase its efficiency. David, welcome back to the Trader TV.

David Scilly Thanks for having me again, Dan.

Dan Barnes So tell me, how does FX trading relate to other instruments and is it just a cost?

David Scilly Certainly when you’re looking at it from the point of view of just buying or selling a security, and actually needing some kind of money to actually pay for that security, you could argue that it is just a cost. But one thing that people probably don’t understand is, that if you’re taking on currency risk, the currency decision and the timing around the currency execution, is just as important sometimes as the investment return on that local asset. Obviously, you still have to be concerned about liquidity. You have to be worried about market impact, the transaction costs, all these things. But obviously the structure of the FX markets are a little bit different. It’s a little bit more evolved, there’s a lot more electrification, there’s a diverse range of market participants. You’re talking about everything from retail through to wholesale. And then it’s also a very fast moving market, so, you have to actually be a little bit more reactive and have different approaches to execute different strategies.

Dan Barnes And does have some of the same challenges you have with implicit and explicit costs?

David Scilly It does have implicit and explicit costs. It probably is more, ‘what is my cost that I can actually see right there at that point in time,’ versus, ‘what my slippage and also my market impact is,’ so not just the time that you’re doing the trade, but it’s also the market movement after you’ve done that trade.

Dan Barnes What constitutes best execution in foreign exchange?

David Scilly You need to understand the liquidity that you’re actually participating in and where it’s coming from. You also need to be very transparent, obviously, in how you actually show the stuff to the market, how you signal to the market. And finally, you need to actually provide evidence, if you like, on your execution decision about why you made the decision you made, to execute that particular way.

Dan Barnes And how would you characterize the FX markets over the last 12 months?

David Scilly Our spreads have definitely narrowed in developed markets and in emerging markets, there have been some cases where they’ve widened, depending on the geopolitical risk. Banks have, for some time now, had reduced risk appetite. But what’s actually happened is, because of the electrification, because of the expectation from the buy-side as well about, you know, the pricing that they expect to see, banks have actually increased their transparency in terms of what they’re showing, in terms of live executable pricing. They’ve increased the size and the limits of which they’re prepared to show on screens, which are executable prices. And they’ve also been quite prepared to clear that risk at probably a faster level, so, whilst they haven’t warehoused their entire bank risk, they’ve actually still been willing to offer good transparency. But the risk gets cleared in a much quicker fashion than it used to.

Dan Barnes You mentioned the banks have less risk appetite. Why do they have less risk appetite in FX compared to other sort of more risky assets?

Dan Barnes They have less appetite for warehousing some of the risk, now. I think that’s been the case for quite a long period of time, but they are offering us quite a large size now on screens and executable kind of levels on screens, and being very transparent with that. So, I think that what’s happening is they’re finding better mechanisms in order to clear their risk.

Dan Barnes How has that affected the way that buy-side traders are interacting with FX?

David Scilly So, you need to be aware of a few things. I think you need to be using all the execution strategies available to you. You have to understand the liquidity, as I said, that you’re interacting with. You have to be aware of algorithms and how you can use algorithms at times. You have to be aware of who you show certain prices to. And as I said, you have to be aware as well of that market impact or the slippage, if you like, that will happen after that trade has been executed.

Dan Barnes Out of interest, If there’s a capacity to automate more in FX trading, is it worth investing in systems to make that happen or is that something typically the sell-side provides?

David Scilly The sell-side has actually increased its level of automation just by the pricing it’s shown, which is great. And they definitely increase their size in terms of what they’re prepared to show on screens, which is obviously providing more opportunity to use that. I do think that more automation could be done from the sell-side in terms of the currency pairs that they’re currently showing, understanding that obviously they can’t show prices all the time in every currency pair that’s available. It has been increasing, which has been a good sign. And I think that ultimately we want to get to a point where we can interact without necessarily having to get on the phone and make the call on that risk transfer price, but just interact with the electronification they’re providing.

Dan Barnes And are the underlying economics for supporting automation less interesting on the buy-side, because FX is not an investment, it’s a cost of investment?

David Scilly That’s a fair point. I haven’t really looked at it that way, I have to say, because obviously, you know, for me FX is a very important part of our business, like we have active capability as well. Having said that, you’re right. It’s it is something which everyone needs to do. So, what you need to do is obviously try and lower the cost as much as you possibly can. The easiest way to do that would be to increase that transparency, give buy-side or empower the buy-side to actually be able to make those executions themselves, without actually affecting their impact and their reputation on the market by doing so.

Dan Barnes So you’ve got a drive for greater efficiency. You’ve got implicit and explicit cost to manage. How are you tackling those challenges?

David Scilly Trade cost analytics are really important in FX, both pre- and post-trade. We’re looking at trying to assess, and then looking at the opportunity costs, which, when you’re getting prices in real time, its very hard to distinguish sometimes. It’s hard to kind of model both scenarios and try and work out which is the better scenario, because it is in real time. But that’s the way we’re trying to tackle it,  we’re trying to look at how we approach one execution decision, look at the cost of that, and then trying to assess it, if you like, with another execution decision at that point in time, to try and work out whether we would have got a better outcome. That’s where TCA and some of the modeling in TCA is actually very important to help with that.

Dan Barnes Are you using anything like the auto-hedging capability of some of the platforms are offering?

David Scilly We’re not doing that yet. We tend to use our own tolerances and kind of manage those decisions ourselves, because we like to have control over the size and liquidity and the timing of which we do that FX execution. So, we’re not currently using auto-hedging.

David Scilly So, how would you say you’re increasing execution, quality and efficiency for investors over the longer term?

David Scilly So we’re assessing those opportunity costs and those different scenarios, as I suggested. We’re looking to try and minimize the market impact, that we’re having as an institution as much as we can. But the key part of it is this continuous improvement pace, which is to look at the execution that we’ve done, compare it to the scenarios that are available to us, and making sure that we’re actually reducing costs in the long-term for the client.

Dan Barnes David, thank you very much.

David Scilly Thanks for having me.

Dan Barnes I’d like to thank David Scilly of First Stage Investments for his insights into FX trading and of course, you for watching. To catch our monthly reports on other markets or to subscribe to our newsletter, go to TraderTV.NET or ETFTV.NET.