Ever get the feeling that every time you turn around, a new FX trading platform is springing up? Philippe Bonnefoy sure does.
"I went to an FX dinner in Zurich where every single person in the room seemed to have an FX brokerage," said Bonnefoy, who is chairman and chief investment officer of Newscape Capital Group.
"I think one of the reasons is it's not particularly expensive to set one up. It's pretty easy to do and you back-end it into one of the banks and there are now almost whole packages you can buy to do that," he said.
"I went to an FX dinner in Zurich where every single person in the room seemed to have an FX brokerage."
In the wake of a slackening of trading volumes in equities, forex has been very much the go-to market for algorithmic traders. Anecdotal evidence and surveys (including the latest from Automated Trader) show that the trend to move into FX has shown little sign of abating. This seems to be true of the buy side, the sell side and vendors who are developing products and services for the market.
But a central question remains: is there really enough appetite for all these new platforms? Are there enough flows to make them profitable? On that, the market is sceptical. Many predict that a number of the new trading venues will shut down over the course of the next year or so.
But for now, many on the buy side and sell side - as well as the vendors - are still piling into the FX arena.
For one thing, size matters.
"We really like the FX space - because $5.2 trillion a day trades in it. It's the largest market in the world," Bonnefoy said, estimating that it was some 25 times the size of the average daily traded value of the US equity market.
What is more, he said, few funds seemed to specialise in FX.
"The idea is to take some of our quantitative models we've spent years developing and apply them in a bit more of an intuitive way to other parts of the FX markets and other parts of the interest rate curve," he said.
Thomas Pasturel, head of research and development at Pecora Capital, also noted it was rare to find FX-only funds, at least in the area where his fund operates.
"There are very few alternative asset managers out there who focus primarily on spot FX," he said.
Pasturel's managing director, Aaron Smith, said he saw potential for enormous growth in terms of asset management trading of FX, akin to the growth he saw in managed futures since about a decade ago.
"Dedicated FX-only hedge funds only account for about $50 billion, which is an incredibly small proportion of the overall hedge fund universe," Smith said. "The possibility for growth there is quite high, just simply because we bring liquidity, efficiency."
Rob Gray, head of EMEA sales for the differentia unit at Dion Global Solutions, said currency markets and algorithmic trading are a natural fit.
"Certainly the hedge funds that are familiar with algorithmic trading in equities wouldn't find it difficult to make the transition to FX."
"FX does lend itself very well to algorithmic trading and it's quite a simple asset class, really. There's nothing too complex about FX," he said, emphasising the market's bias towards technical trading.
"All these companies are springing up from Cyprus or wherever and trading yards and yards of FX volume," he said.
Gray said that for hedge funds making the transition from equity trading, the journey is not all that onerous.
"Certainly the hedge funds that are familiar with algorithmic trading in equities wouldn't find it difficult to make the transition to FX. FX is a highly liquid market - you know, there's not much difference from their perspective of looking at FTSE 100 stocks and G10 currencies," Gray said.
"If you're using algorithmic trading and you're using technical signals, there's no reason you couldn't apply some of those technical signals on the chart to British Telecom as you could to euro/dollar."
He added that the same logic could be applied to less liquid currencies: firms that had developed strategies for trading less liquid AIM stocks could apply those same signals to currencies such as Thai baht or the Brazilian real.
Smith of Pecora was dubious about moving into more exotic currencies. "I'm not sure of the utility of something more exotic when you have better liquidity in the majors, and if you want essentially the same risk you can just leverage a major position as compared to a less liquid exotic pair where you're not going to get a very good spread," he said.
Eyes wide open
Meanwhile, as investors have rushed to focus on foreign exchange, so too have other service providers.
ITG Chief Executive Rob Boardman said his brokerage had identified FX as a market to develop services for, and spent a lot of time learning about the way the market operates.
"When you start to take an interest in another asset class, the first thing to do is make sure you go in with your eyes open."
"It's very different from the equities domain that we've lived in since we formed in 1987. In Europe, we have a long history of being deeply specialised in one asset class. When you start to take an interest in another asset class, the first thing to do is make sure you go in with your eyes open," Boardman said.
For ITG, the most natural route was to focus on analytics. "Before we started hiring traders or building trading platforms we wanted to actually learn about how the market worked at a deeply quantitative level."
ITG, he said, is known for its transaction cost analysis (TCA) analytics and it believed that would be an ideal place to start. "So we built models for how FX and FX-related products work, whether it be cash or forwards, and we decided that we would launch our first product to measure transaction costs."
As it was, that worked out well because it came during a period of high-profile lawsuits by asset managers aimed at custodians in the US.
ITG found, surprisingly, that while plenty of investment groups performed TCA for their equity transactions, few firms were systematically measuring what they were doing on the FX side.
"The upshot of that was we found strong interest amongst asset managers to start measuring this effect, often dictated by fund trustees. There's nothing like the whiff of scandal to encourage people to take on a new measurement product. So that was actually very strong, and almost outstripped our immediate demand to supply it."
And while trading FX - according to Dion's Gray and others - may be relatively straight-forward, doing proper measurements of your trading is not.
Boardman said it took ITG the best part of two years to build a product for the FX market. One of the chief reasons: sourcing good data.
"We're used to being able to get bulk data in real time very quickly and buy that in. In the FX market, it's still almost exclusively over the counter, so there are private sources of data that you have to negotiate to get access to," he said. "The lengths to which you have to go to get data I think did surprise us."
Boardman said ITG is now building algos to trade foreign exchange, moving from a purely analytics service to a trading offering. But he is glad the firm took the route it did. "I think for us to start with trading would have been very foolish. We wouldn't have known about the market, we probably would have made some mistakes."
ITG, he said, has had a long-standing commitment to diversify and to be multi-asset class. "We think that it's a natural evolution to move into FX trading given that we already have clients who trade global equities and require FX. An easy start for us will be algorithms on the back of equity-related flows."
Even so, while many thought in 2012 that FX was the ideal alternative to equities, given its size and liquidity, even that market has not been immune to the doldrums. Executives at banks and other FX-oriented firms say flows have eased some 30 percent from a year earlier, possibly even more.
"One of the reasons we've got … very little volatility is just this tidal wave of quantitative easing that's dampened activity," Bonnefoy said. With authorities throwing money at problems, any spark of volatility has been dampened.
As for all those new platforms, the view from many other executives is that there will be a relatively high failure rate. One reason, market participants note, is that many of these firms appear to be employing an A book/B book business model, with the less successful traders going on a B book where the brokerage will often not hedge their positions and will effectively trade against them. Finance websites are full of posts of frustrated day traders who learned the existence of this practice.
That business model, Bonnefoy said, requires constant advertising and on-boarding of new clients. "These machines have to continue to move forward to intake more clients before those guys (on the B book) run out of money."
At the same time, the big banks are doing as much internalisation as possible, with rates hovering between the mid-80s to the low-90s.
"Many of them want to move that number up towards like 98 to 100 percent. Their goal is to internalise all flows they can. So the question is, is it only the auto-hedging flow that they're sending out?"
Courtney Gibson, vice president of trading at FX brokerage OANDA, said retail flow had not changed a great deal but institutional flow was down 30-40 percent. "We're still assessing how much the institutional flow has backed off right now because we're not seeing a matching decrease on the retail side," he said.
"It becomes harder and harder - as you go from 10ths of a second to 100ths of a second to 1,000ths of a second to 10,000ths of a second - to start to make those decisions."
"Some of it is because of central bank intervention. If Switzerland pegs the franc, you know there's not going to be much volatility - but it also means people who have Swiss franc risk can peg their risk a little more."
As a market-maker, OANDA builds in-house algorithms for price creation. It hasn't offered them to its clients but it is considering doing so.
Gibson said one challenge, which would be important for many market makers, concerned high frequency trading.
"It's shaping the landscape in a lot of ways. The options folks have had to deal with this for a long time because the rate of price updates in the market is huge compared to the forex space. The FX spot rates are updating hundreds of times a second now as opposed to thousands or tens of thousands (in options).
"There are two challenges there. One is creating systems that can deal with the heavier flow, and we're seeing heavier and heavier and heavier tick volumes come through in the market," he said.
"The other important one from a consumer standpoint is providing a clean flow of prices. As you get faster and faster, as you're bringing in prices from all of your liquidity providers … you get unclean data from your price providers. It's just a factor of doing business in the market place," he said.
OANDA invests a lot into cleaning up pricing. "It becomes harder and harder - as you go from 10ths of a second to 100ths of a second to 1,000ths of a second to 10,000ths of a second - to start to make those decisions," Gibson said.
A market maker doesn't want to give bad prices but also doesn't want to miss market moves. "Algorithmically, there's a lot of research that needs to go into making sure that you're passing the sudden market moves through as quickly as you can but you're not passing through the sudden market mistakes that show up."
Along with the growth in tick data, fund managers are also finding that they're having to adjust to the proliferation of new trading venues and the emergence of HFT activity in currency markets.
"It makes the environment very complex," Pasturel of Pecora said.
"You have to take many things into account, not just the volumes and the spreads, but technology as well. Some liquidity providers are in LD4 in London, others in NY4 in New Jersey. There are many aspects to consider in order to achieve optimal trading conditions." He also said his fund keeps a close eye on who are the stakeholders of various venues.
One corner of the market has already pushed back against the HFT segment. Banking groups have been frustrated by the way FX spreads have narrowed with the emergence of so many high frequency players. Wide spreads had historically been a lucrative revenue stream for an industry that has acted as a core liquidity provider; a sign of just how much this had become an issue came with the recent decision by EBS to scrap the fifth decimal point in FX quotes. It now allows only "half-pip" pricing, meaning the fifth decimal could only be either a five or a zero.
High frequency traders, looking to profit from ever-smaller gaps between bids and offers, had been quoting in the fifth decimal and the EBS move was seen as an unmistakable push back in favour of the banks.
Pecora, whose trading horizon can range from minutes to hours to longer, does not engage in HFT activity, though Pasturel said he keeps a close eye on what these firms do because of the technology they employ.
"One of the important things as well is the ability to be scalable and to do a very large number of calculations while doing some simulations, especially robustness of tests and stress tests. That's extremely demanding in terms of computing power," he said.
For instance, Pecora has a goal of being able to run 100 million back tests, simulations and robustness tests over about 24 hours, a goal it says it is getting close to.
A point of interest
As for trading approaches, both Pecora and Newscape have noted the dominance of the risk-on/risk-off trends which have been so prevalent, especially since the 2008 crisis.
The critical question will be when the market begins to believe that interest rates are finally set to start rising, Bonnefoy said.
"When people do begin positioning for change, is it going to be a massive tsunami or is it going to be a gentle push and then all the sudden a much stronger push later?" he said. "Do we see a risk on/risk off trade - is it going to be a slow evolution that begins gathering force?"
He believes his own fund is ready for either a slow or fast-moving market.
"We spent a lot of time doing research and development. In this environment, should we not have a near-term catalyst for volatility to change, we've also developed models that do well in low dispersion environments, and that's been essential to be able to craft a fund that has the ability to do well in all kinds of market environments."
At Pecora, Smith said the degree of market correlation has allowed it to express nearly any trade idea it wants purely through liquid FX pairs.
"So if we have a view on Japan, if we have a macro view in any specific area, it's likely that we're able to express that view through a position in FX," he said, noting that unlike some other quantitative investment firms, his group does develop a macroeconomic overlay for the systematic trading it engages in. "So for us it doesn't make sense to be allocated purely to a short-term trend-following system, for example, when we're at a five-year low in volatility. "
An example he gives concerns the firm's global outlook with a specific focus on Japan. "Another hedge fund … might express that today through taking a long position in Nikkei or Topix or taking a short position in Japanese government bonds. I feel like the most efficient way to get exposure to the Japanese story is by having a position in the yen versus a basket."