BIG TICKETS OR BIG HEADACHES?
Most institutional clients from time-to-time face the challenge of hedging large exposures in foreign exchange, but if market liquidity is not utilised in the most effective way it could cost these firms millions of dollars. Christian Bock, Head of Sales Europe & North America at ADS Securities looks at how best execution can be achieved.
There are many stories of institutional firms who have lost out because they have inadvertently caused an adverse market move. There are cases of companies who have split business between traders only to find that they are actually competing against each other in an otherwise quiet market. Or of companies who have simply been given unfavourable executions because they did not know at what rate best execution could be achieved. The good news is that with new technology and a better understanding of the process best execution can be achieved. One of the first issues to address when placing a big-ticket order with a bank or a broker is the simple fact that the trader might be front-running the execution. This can be very costly and is very difficult to prove in an OTC (Over the Counter) market. The smallest hint that a large transaction is going through means that some traders will buy or sell for their own advantage. This behaviour is unethical and most market participants will do their very best to avoid such patterns among their traders, but it can be very difficult to detect. ‘Front-running’ on a broader base could in theory happen for non-malicious reasons. It could be that the individual trading desk might have to cover pre-existing orders. If this does happen it becomes very difficult to say which average rate should apply for which client, or whether it should be the average of all trades which should be used. Either way, it is likely to have a negative impact on the overall result. The second issue faced by institutions is whether they deal with one specific market maker or several market participants, which then allows prices to be compared. Both options present different risks. If a number of market participants are used it is likely that the trade will be leaked. Traders will interact with the market and the required rate will be lost. However, if the institution talks to just one bank their hedging requirement may not fit into the current position of the bank’s trading desk. If they already have large positions on their book the bank’s trader will have no other choice than to show a price further away from the market, as they take into account what is already being processed internally. This generally results in the average rate of the fill becoming less favourable. Additionally, it is possible that it will become more difficult for the trader to quietly place the order in the market, therefore the trader may have to be more aggressive in his or her trading style, which may lead to an overreaction from the market, which will result in a less favourable execution for the client. In both these cases it can be advantageous to clear business via a Prime Broker or Central Counterparty to ensure that anonymity is given and no-one, except the Prime Broker knows about the flow before – and after – it has been executed. The perfect solution is to have as many market participants’ liquidity as possible, keep the trade confidential and avoid human error. There are a number of new market participants who are developing this solution and who allow the aggregated spread to become narrower than the spread any given liquidity provider will be able to provide. They can offer the most aggressive bid in the market as well as the most aggressive offer available. This approach also has the advantage that the full depth of liquidity is visible, including the corresponding spreads (often referred to as ‘liquidity smile’: the full display of liquidity available at different bid/offer spreads), which reflects current market conditions and helps to enhance the overall liquidity. By having access to the full market with a high number of liquidity providers behind it, the client can easily judge where the ‘real’ market is at any given moment. This includes the natural buying interest on one side versus natural selling on the other side, which provides a positive benefit by narrowing the spread, rather than having the market trading away. If this solution is adopted the most important question is deciding who to clear through, or more exactly, which Prime Broker to use. Most providers will offer a number of options from which the best-fit partner can be chosen, based on what settlement limits and which trading lines exist for the corporation. The other option is to allocate a certain amount of business directly to selected partners and dedicated liquidity providers, but at the same time use the service of specialised brokers to conduct business that exceeds the day-to-day business and requires special care for the best execution. This guarantees favourable execution and helps to provide anonymity and protect the client’s name. Another problem in placing large trades is the potential inefficiency of the human trader. Traders have been known to overreact in certain situations or conversely not react quickly enough. To avoid this, a significant number of corporations and institutional clients have started to use algorithmic trading solutions, which can provide improvements in execution without the risk of human error. The underlying concept is to make the execution more reliable and, over a period of time, produce more effective results. The biggest advantage of algorithmic trading is however also its biggest disadvantage in that all executions will average. This means it is not very likely that any execution will be at the peak, but at the same time it is very likely that the execution will be on a sound middle basis of where the markets were at the time. Another advantage of algorithmic trading is that it can be bespoke. It can be programmed to execute exactly how the user wants, in terms of timing and volumes. The most commonly used execution style is the time slicer, also known as ‘time weighted average price’, which will allow the user to define a period of time during which the machine will execute parts of the order, often in random time intervals and in random sizes, to ensure that no other market participant can detect a trading pattern. This obviously works best in combination with anonymous trading, where the order will blend in with other business going through the same broker. This combination will make the order ‘invisible’ for all other market participants and ensure total discretion. The trend in the market is clearly going towards automated or algorithmic execution. At the same time, it has become clear that aggregation of liquidity is mandatory for execution of big orders. A number of providers have stepped into this new environment and are delivering tailor made solutions for institutional clients. These providers have the resources to invest in the latest technology required to give the best execution. So, putting big-ticket trades into the market is no longer the headache it used to be. With 2014 looking like a year when there will be increased volatility the ability to hedge quickly and efficiently will be a great advantage. ©Best Execution 2014