Algo sniffers make a tough business tougher

Passive algorithms have been one of the big success stories in spot foreign exchange in recent years. In the low-volatility environment, and even during the Covid-induced vol spike last year, market participants have been keen to use the algos to place bids and offers on electronic venues that are skewed, or discounted, to encourage other market participants to take you out of the risk.

The benefit is that they allow the user to avoid having to pay a bid/offer spread to move the risk. The main drawback, though, has always been market risk – this approach takes longer to execute, so there’s more chance of an adverse market movement.

But in the past 18 months or so, another risk has emerged. When trading on anonymous platforms which bring all users together in once place, showing a skew can be a great flashing beacon to tech-savvy market participants that flow is coming that might move the market.

These firms quickly update their prices to match the skew, forcing the passive algo user to skew even further to attract the flow needed to take them out of the position. In essence, it forces them to buy higher and sell cheaper than they otherwise would have, making hedging more expensive and ultimately resulting in less profit for the LPs.

Algo teams at the large liquidity providers are trying to fight back by creating bespoke liquidity pools without these skew snipers in there. But working out exactly who is a fox in the henhouse is a challenge, so LPs – with the help of the platforms – are running all manner of tests to spot them and kick them out, to make sure their stream is safe to skew on.

These tests aren’t always perfect, though, and there’s a risk that some users get unfairly penalised for what they believe is legitimate trading behaviour.

Another downside, of course, is that if LPs whittle down their liquidity streams on these platforms only to those deemed “skew safe”, there are fewer potential counterparties to take them out of the risk. That means it takes longer to get out of positions, and therefore results in more exposure to market risk.

But as FX volatility heads back down towards its pre-Covid lows, that appears to be a risk worth taking – particularly as the resulting shrink in bid/offer spreads, fierce competition and ongoing technology costs make the business an increasingly difficult one to run for many LPs.