Auto and algo trading techniques are being deployed by a wide range of buy-side firms in the increasingly crowded, but not always transparent, waters of the FX market. Chris Hall reports.

Buy Side Flocks to FX

The shotgun wedding between quick-on-the-draw automated traders and the venerable but slow-moving institutions of the FX establishment was a short-lived and tempestuous affair. Plenty of ‘Wham! Bam!’, but ‘Thank you, Ma’am’ was an uncommon courtesy as the new century introduced new trading technologies to the FX markets. The term latency arbitrage was coined to describe the highly-profitable strategies employed by hedge funds to exploit differences between the prices a bank would quote on different market channels. Banks retaliated, first by shutting off liquidity to hedge funds that persistently used high-frequency trading techniques to skim risk-free returns, then by deploying algorithms of their own to react more swiftly to price movements and provide liquidity to multiple electronic platforms.

Rather than precipitating a Cold War-style stand-off, a sense of mutual dependence has nurtured a policy of accommodation and entente cordiale. High-frequency statistical arbitrage still plays a part in buy-side activity in the automated FX market, but it is augmented by a wider range of strategies and time frames. Banks have broadened their perspective too. The investment required to handle large volumes rapid-fired from automated trading systems has opened up new revenue streams, with traditional asset managers eager to use execution algorithms and other advanced trading tools to bring their FX execution capabilities up to the standards already achieved in equities.

The resultant leap in volumes and, therefore, liquidity stands to benefit all. Total FX turnover reached USD 3.2 trillion in April 2007, according to the Bank for International Settlements’ Triennial Survey, a 71 per cent increase on 2004. Much of this is attributed to a huge rise in buy-side participation. Transactions between broker-dealers and buy-side financial institutions (hedge funds, mutual funds, pension funds and insurance companies) have more than doubled in three years. Trade volumes between brokers and buy-side institutions (40 per cent) are now almost equal to inter-bank transactions (43 per cent). The FX market now resembles less a warring marriage than an online speed-dating service, where the needs of a diverse range of parties can be matched. ...

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