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Best execution: what role do FX algos play?

Pete Eggleston
Pete Eggleston
Co-Founder and Director at BestX

Market participants are increasingly incorporating FX algos in their best execution process, but this doesn’t mean they are the right option every time.

The use of execution algorithms in the FX market has increased significantly over recent years and it would appear that this trend is set to continue for the foreseeable future. This is partly due to the growing focus on best execution.

Under the MiFID II European directive, best execution requirements mandate firms to take all sufficient steps to obtain the best possible result for their clients, taking into account a variety of factors.

However, this is unlikely to be the only reason for the surge in interest.

Benefits of using algos

Algos can offer tangible value to the best execution process, other than simply delivering the requisite time stamping and transparency required by regulations.

The benefits of including algorithms in your menu of execution options include:

  • Potential to reduce costs
  • Potential to reduce market impact, especially for larger tickets
  • Ability to access a wider range of liquidity sources
  • Operational efficiency
  • Transparency and audit trail

However, there are also potential risks associated with algo use, which need to be considered as algos don’t necessarily deliver a ‘best execution magic bullet’.

Potential pitfalls

Algos present clear benefits and can help contribute to achieving best execution in some circumstances, but they are no panacea. There are potential pitfalls to be aware of when using them:

  • Cost vs. performance trade-off

The temptation is to use products that appear to cost the least.

However, a product that might appear relatively expensive in terms of headline cost, might on average deliver far superior execution performance when taking into account market impact and other factors.

  • Market footprint and signaling risk

Poorly designed algos or sub-optimal selection and management of liquidity sources may create significant market impact, compounded by allowing other participants to further identify the algo behavior through the signaling risk it has created.

  • Marketing spin and black boxes

Understanding exactly what any given product does, and how it does it, can be challenging. The vast majority of market participants are also uncomfortable using any product that might be perceived as a ‘black box’.

  • Liquidity sources

For algos that access multiple liquidity sources, there can be overheads monitoring which providers are delivering high quality liquidity and superior execution, through, for example, low reject rates and rigorous enforcement of participant behavior.

  • Algo selection

Given the bewildering array of products now available, the process of how to select a specific algo, for the trade in question, becomes complex. With the increased focus on FX execution from asset owners, trustees, compliance and regulators, it is more important nowadays to be able to record and justify such selection decisions.

The systematic use of best execution analytics, on both a pre- and post-trade basis, can help mitigate the risks associated with algo use, and allow users to make more informed decisions.

Best execution analytics for algos

Using independent and rigorous post-trade transaction cost analysis (TCA) can help measure performance of algos across providers on a consistent basis, net of fees.

For example, is it worth paying a potentially high fee to use a specific algo, or does the performance over time more than compensate for the fee?

Rigorous analysis can help answer that question, and maybe reveal that “cheaper” algos are not worth the economy on the lower fee.

Furthermore, it is important to not just focus on cost.

There are many other factors to consider when taking steps to deliver best execution, including measuring market impact, assessing price benchmark performance and, for algos specifically, analyzing potential information leakage via measurement of signaling risk.

We partner with BestX, a leading independent provider of FX TCA, to help customers achieve and demonstrate best execution for their FX transactions.

The BestX Best Execution Analytics measures a wide range of best execution metrics for algo trades, as illustrated in the screenshot below.

Sample best execution analysis for an algo trade
Sample best execution analysis for an algo trade

Choosing the right algo

Another common issue is deciding which algo to use and when, taking into account the trade size, currency pair, desired trading objective, time of day, etc.

A number of factors need to be incorporated within the selection process, including whether there is an execution benchmark to consider, or other execution objectives.

For example, it makes little sense selecting a Time-Weighted Average Price (TWAP) algo over several hours if a trade has a specific benchmark of mid-market Arrival Price.

Even with certain standard types of algos, such as a TWAP, choosing between different providers can be tricky.

A rigorous process, informed by independent pre-trade analytics, and based on objective performance measurement, provides the foundations for such a selection process.

Right objectives

Algos have a potential role to play in any modern FX execution process, helping provide efficient, transparent execution in a cost effective manner.

However, they are no ‘magic bullet’ and won’t necessarily always deliver ‘best’ execution.

It is imperative that upon embarking with the use of algos that the potential pitfalls are understood and they are used judiciously and when appropriate to the trading objectives, benchmarks and liquidity conditions.

It makes sense to include algos on any menu of execution options and products, but it doesn’t make sense to always choose them for every meal.

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