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The Multi-Venue FX Algo

Published in Automated Trader Magazine Issue 09 Q2 2008

Ian Smith, Director, and Cameron Mouat, Head of AES FX Trading, Credit Suisse, provide an example of the challenges of trading sometimes illiquid currency pairs and how execution algorithms capture liquidity across multiple trading venues in the foreign exchange market.

The Transaction: A portfolio manager at the London office of a large US-owned asset manager wants to construct an approximate hedge to offset its exposures to the Australasian economies. The Kiwi (New Zealand Dollar) has experienced a 25-year high against the US dollar in recent months due to concerns about a lengthy US recession, but it has encountered resistance at around 0.8210, due to perceived weaknesses in the New Zealand economy. The transaction is aimed in part at offsetting exposures created by buying Kiwi- denominated stocks during the recent NZD surge.

The Challenge:
To place a 250m NZD/USD hedge (i.e. selling NZD), using a target price based on analysis of price movements in the last six months, at the beginning of the UK trading day, when changes in liquidity and market sentiment can impact price significantly. As the hedge is imprecise, the trader may be requested to adjust his position by the portfolio manager, depending on market conditions.

The Algo:
An FX algorithm designed to identify and access liquidity across multiple foreign exchange trading venues and streaming price feeds from banks. The algorithm reacts automatically to changing liquidity levels by adjusting the size of the orders it places on venues to avoid pushing the market if volumes in a particular pair are low. The algorithm works in conjunction with a smart order routing (SOR) platform that shifts orders between venues in real time, based on current factors and historical liquidity.

The Trader:
The trader is an FX specialist working for a large equity-focused conventional asset manager who wants to complete the deal without impacting the market and understands that this may take time.

7.30am: The Kiwi is trading at 0.7927 against the US dollar as the trader configures his algorithm to sell 250m of NZD for USD. Generally, liquidity in the NZD/USD pair picks up noticeably throughout the London morning and all pairs are currently sensitive to any changes in the domestic or global economic outlook, due to continued concerns over the impact of the credit crunch. The trader sets a limit price of 0.7900 and expects the increasing liquidity throughout the morning to work in his favour. He places the whole transaction through the FX algo and expects it to take liquidity at all the price sources to which it has access (i.e. both trading venues and banks' natural interest pricing streams). Initially, the algorithm is set to place offers at the minimum level permitted by individual venues (e.g. NZD 1m on Reuters and less for ECNs with less liquidity), to avoid signalling risk while volumes are low, but will rise automatically to take advantage of greater liquidity later in the session. The algorithm will also aggressively take liquidity at prices which are established without pushing the market to new levels.

7.40am: (Quantity filled - NZD 9m) NZD/USD gently drifts higher to 0.7945 in low-volume trading. The FX algo has a succession of small offers filled across various venues, but with no particular one offering strong liquidity. SOR continues to direct orders in a balanced fashion between venues at low sizes.

(Quantity filled - NZD 37m) Unexpectedly deep liquidity (NZD 15m) located on HotSpot at an established level. This liquidity was not visible due to being an iceberg order, however the algo sends a large Immediate or Cancel order and captures all volume.

8.02am: (Quantity filled - NZD 116m) An increase in liquidity is registered across most pairs and venues following the opening of equity trading in London. NZD/USD starts to trend lower. To take advantage of this liquidity, the algorithm increases order sizes, to NZD 2m on large venues such as Reuters where more trading is seen.

Figure 1: NZD/USD – January 2–April 17, 2008
Figure 1: NZD/USD - January 2-April 17, 2008

8.14am: (Quantity filled - NZD 180m) Orders sent to Currenex reveal hidden liquidity which reloads at an established level of 0.7925. The algorithm reacts by sending repeated Immediate or Cancel orders to capture this liquidity. Additional volume has also been found on Reuters, FXMS, EBS and a bank stream.

8.23am: (Quantity filled - NZD 235.2m) A combination of ongoing negative sentiment in the closing Asian markets and the ability of the algo to identify pockets of liquidity encourage the portfolio manager to request that the trader increase the order to 350m NZD/USD to increase the firm's hedge against its Australasian exposure.

(Quantity filled - NZD 321.7m) Pre-release of bearish speech to be delivered by the governor of the Bank of England combines with pessimistic global outlook from the World Bank to push the FTSE sharply lower and spark a flight to quality that hits the Kiwi harder than the US dollar and NZD/USD falls to 0.7918. The algorithm spreads its orders evenly across trading venues in search of liquidity. However, fills are sporadic as some banks withdraw liquidity from trading venues and their own price streams while the market digests the news. As such, the algorithm reduces order sizes to limit market impact.

8.34am: (Quantity filled - NZD 326.4m) As NZD/USD falls below the limit order of 0.7900, the algorithm ceases trading. As the market has drifted lower, the algo has been required to take liquidity at established levels rather than waiting for passive offers to be traded on.

(Quantity filled - NZD 332.1m) Newswires issue a report of evening speech by the governor of the Reserve Bank of New Zealand to local businessmen, assuring them of the economy's fundamental soundness and comparative

insulation from wider global economic trends.

NZD/USD begins to pick up at 0.7904. The algorithm begins to sense liquidity in small sizes as liquidity returns.

8.45am: (Quantity filled - NZD 350m) Once liquidity has returned to pre-8.30am levels, NZD/USD continues to edge upward toward 0.7915. The algorithm finds most liquidity on the larger platforms with the larger order sizes and the full order is soon completed at just below the arrival price, at 0.7927. Order completed.

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