FX algo users change tack to navigate market doldrums
BestX data finds traders ditching TWAP in favour of more opportunistic execution styles
Since the summer of 2022 until August this year, trading volumes and volatility in the G3 markets have been consistently low, reflecting a broader trend of subdued market activity and volatility across the foreign exchange spectrum. This observation is further supported by data on algorithmic trading volumes from BestX, which reveals a widespread decline in usage across various algo styles, indicating that the market has entered a phase characterised by low volatility and volume.
The prevailing conditions are thought to be driven primarily by the high risk-free rate in the US and a robust equity market, which together reduce the incentive for capital flows and diminish the demand for FX trading services.
One response has been for market participants to adapt their use of execution algorithms. As figure 2 shows, the opportunistic style has emerged as the most popular among the BestX option pool – representing more than $50 trillion in client assets under management and 161 trillion trades – over interval and volume algos.
This group includes an array of products that don’t have a specific benchmark which they are trying to match. For example, they could be implementation shortfall algos, unencumbered by a strict schedule and dictated by a benchmark with the flexibility to execute aggressively or passively, which can adjust depending on market moves. Urgency is often a key parameter in this style, determining how passive the algo is prepared to be to earn spread.
Meanwhile, volume algorithmic styles – which aim to execute in line with a specified percentage of volume traded within the market – have all but disappeared.
In this challenging environment, the pivotal question for both the sell side and the buy side in the FX industry revolves around how to effectively navigate the prevailing conditions and prosper. Embracing Darwin's principle of adaptability is essential. It is crucial for stakeholders to remain abreast of the latest trends and adapt their strategies accordingly if they are to succeed.
Sophistication in vogue
The industry’s increasing trend towards transparency has led to notable changes in the use of algorithms.
Looking at the data depicted in figure 3, a fascinating evolution in the use of various algo styles is apparent. Simpler algorithms such as time-weighted average price (TWAP) and volume-weighted average price (VWAP), which were once dominant, have lost favour among the buy side.
In contrast, more sophisticated algos like implementation shortfall and arrival price, categorised by BestX as opportunistic styles, have gained preference among clients. The opportunistic algorithm typically involves a more advanced execution strategy. For instance, it could balance spread cost and opportunity cost, and adjust based on urgency settings and other dynamic market factors. This allows it to optimise trade execution by taking advantage of favourable conditions as they arise.
Opportunistic algorithms generally present lower signalling risk, capture better spreads and thus deliver superior performance compared with simpler alternatives such as TWAP or VWAP.
Figure 4 illustrates that the risk transfer performance of opportunistic algorithms consistently exceeds that of other styles. The triangle represents the average performance across different styles, while the blue bar indicates one standard deviation. The risk transfer price performance is the final execution price of the algorithms benchmarked against the arrival mid, adjusted by the expected cost model. This metric is particularly popular among the buy-side community for evaluating the performance of algorithms.
This positive narrative underscores the fact that high-performing algorithm providers are increasingly favoured, leading to better outcomes for clients.
Yangling Li is the head of analytics and quantitative research at transaction cost analysis provider BestX.
Editing by Joe Parsons
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