Trading Place

How choosing the right marketplace can help hedge funds optimise their FX performance

Mark Warms, General Manager, Europe, FXall
Originally published in the August 2005 issue

The foreign exchange market is the largest and most liquid in the world, and more money is flowing into it than ever before. The latest triennial survey by the Bank for International Settlements (BIS) revealed that daily foreign exchange turnover had risen to $1.9 trillion, up from $1.6 trillion in 2001. Driving this growth is a sharp increase in trading from non-bank financial institutions – by pension funds, by asset managers and, most strikingly, by hedge funds. According to the BIS survey, 'trading between reporting banks and other financial institutions, mainly hedge funds, mutual funds and insurance companies', grew more steeply than any other segment of the market, increasing by 132% between 2001and 2004.

The emergence of foreign exchange as an asset class

The comparative volatility of the currency markets has certainly played a part in this boom. Faced with lackluster equity markets, investors have been drawn to foreign exchange, where economic and geopolitical uncertainties had created instability and hence greater potential for alpha. Currency is also uncorrelated to other asset classes, making it a valuable component of any institutional portfolio. These qualities have attracted the attention of banks and investment houses, many of which – including Deutsche Bank and ABN Amro – have recently launched currency portfolios to capitalize on the growing interest in FX as an asset class.

The currency markets also appeal to hedge funds and other active traders because they offer significant potential for leverage. For major currency pairs, banks can let customers trade on two to five per cent of margin, meaning that a hedge fund with just $10 million can trade a $200 million position in and out of the market in a single day. In this way, smaller players can punch above their weight in a way that is much harder in the fixed income or equities markets.

Finally, there are now simply more hedge funds and other alternative investment vehicles around than there were in 2001, being given more money by institutional investors and wealthy individuals to invest both in currencies and in other asset classes. Together, these factors have created a 'perfect storm' to drive foreign exchange trading by hedge funds to unprecedented levels.

The role of electronic trading

Online foreign exchange portals, which enable hedge funds to rapidly move large amounts in and out of the market, have also contributed to the rise in volumes. Electronic trading is fast and efficient enough to support even the most dynamic trading strategies, and gives hedge funds access to deep liquidity from multiple sources on a single screen. By increasing the speed of execution, online portals have made it possible for hedge funds to push larger trades through the markets, at higher frequency. Through improved price transparency, they have made it far easier to achieve best execution and get the optimal price on every transaction. These advantages have led to existing foreign exchange traders increasing their trading volumes, and new ones entering the market.

Sophisticated, dynamic and demanding customers

According to a recent report by industry analyst Greenwich Associates, hedge funds are some of the fastest and most enthusiastic adopters of online foreign exchange trading services. Almost half (49%) of hedge funds now trade forex online, up from 36% in 2003. A further 17% plan to start trading electronically in the foreseeable future. Hedge funds also make up one of the fastest-growing sections of our own customer base. From less than 6% in 2002, they now account for around a quarter of trading volumes.

Hedge funds are also pioneers of model-driven trading, in which trading decisions are made by complex computer programs that track markets and execute when certain conditions are met – the parameters tracked by various models can range from currency prices to trading volumes or price movements in related markets. By managing individual trading decisions, these models free up traders to focus on monitoring overall market position and developing new strategies to generate alpha.

Any fund that has made a significant investment in trading technology needs to be sure that its trading partners – whether these are individual counterparties or multibank portals – are operating at a similar level of technological sophistication. A manager needs to evaluate how long it takes to execute a trade from start to finish – if a provider can't keep up with a manager, it doesn't matter how fast the trading technology itself is.

Choosing the right marketplace

The Greenwich Associates research also found that hedge funds consider faster executions (mentioned by 65% of respondents) and convenience/efficiency/increased productivity (cited by 43%) to be the two most significant benefits realized by trading foreign exchange online. Funds also value automation, with STP, reduction in trade errors, and the ability to track trades all cited by more than 20% of respondents. Increased liquidity in major currencies and the ability to trade anonymously were each cited by 18% of respondents.

Clearly, to derive the maximum benefit from electronic foreign exchange trading, hedge funds need to choose a platform that delivers all these benefits. But what features should funds look out for when selecting an online foreign exchange platform?

To achieve faster execution, funds need to choose a platform that delivers high-speed connectivity through an API or FIX interface. Deep liquidity – cited as an important benefit in itself – also makes it easier for hedge funds and other active traders to fill large trades, at tight prices, in seconds.

The ability to trade anonymously is cited by almost a fifth of hedge funds as a key benefit. Other funds may want to disclose their identity to their counterparty – leveraging the power of their banking relationships to get tighter prices or deeper liquidity – but will not want to alert the rest of the market to their trading activity. Whether they want to trade confidentially or in complete anonymity, it is important for funds to select a platform that supports this.

Many of the other benefits – convenience, efficiency, productivity, STP, ability to track trades and reduction in trade errors – can be achieved through automation. Hedge funds are increasingly looking for platforms that go beyond execution to automate the full transaction lifecycle, including prime brokerage messaging and the instantaneous download of trade details into portfolio management systems.

Optimize your FX performance – four steps to more efficient foreign exchange trading

High-speed connectivity

Speed of execution is crucial for hedge funds, especially for those that have invested in algorithmic trading models. If there is any slippage between the time the trigger to buy or sell is generated, and the time the trade is executed, the fund loses out – and loses one of the main advantages of algorithmic trading models, the ability to trade instantaneously when the market hits a certain point. To execute every trade as closely to the signal as possible, hedge fundsneed high-speed connections that make it possible to request and execute a trade within fractions of a second. Since every fund will have their preferred connectivity method – for example, Java, Microsoft COM or FIX – they should look for a platform that supports this, rather than one that requires them to install new technology.

FXall has invested heavily to enable active dealers to connect to the platform through a wide range of connectivity options, including Java*, Microsoft's COM* and FIX. At the end of 2003, FXall began work with FIX to set up a FIX working group for foreign exchange, which is co-chaired by FXall's CTO, Jack Lemonik.

Instant access to deep liquidity

By linking to a continuous streaming prices service, rather than a request for quote service, hedge funds are virtually guaranteed a permanent source of liquidity. This ups the chances of achieving the rate initially targeted. To make sure orders get filled quickly, funds should also make sure that the platform they choose offers deep liquidity in major and exotic currencies from a broad range of liquidity providers.

A completely confidential trading environment

Understandably, hedge funds place a high value on confidentiality, and the ability to take large positions without alerting the market Confidentiality is therefore central to any fund's choice of trading platform. It is essential to select a model where transaction details remain completely confidential between the customer and the liquidity provider, and are never published to the market. As well as confidential trading, a good provider should also offer the ability to trade anonymously through a prime broker.

End-to-end automation, from execution to prime brokerage messaging

Automating the full deal lifecycle makes trading quicker and more efficient, as well as reducing costs and minimizing operational risk. It is therefore important to select a trading platform that automates the full deal lifecycle, rather than one that just offers execution.

Leading automated platforms such as FXall provide comprehensive reporting tools that give hedge funds a summary and analysis of every dealing decision, along with a full audit trail of all activity. Trades are tagged with user-defined fields, making them far easier to track.

For hedge funds, prime brokerage messaging has historically been one of the most cumbersome elements of the foreign exchange trading process. It is typically a laborious, manual procedure carried out by middle and back office staff. The high dependence on human intervention increases costs and risks, and means that errors can take hours or even days to resolve. FXall has addressed this problem by creating an automated prime brokerage messaging solution. This application enables the automated exchange of give-up messages in real-time, so that all counterparties receive a timely notification of the status on any deal.

*Java is the registered trademark of Sun Microsystems; Microsoft COM is a trademark of Microsoft Corp.