WHEN CLIENTS ARE TRADING SMALL CLIPS, ANYONE CAN BE AN LP.
Deep liquidity and technology are now vital for clients especially those executing large clips in different market sessions, says Nedal A. Hadi, Head of Institutional Sales at ADS Securities.
For the last two years the FX market has been in search of genuine, deep liquidity. New regulations and greatly improved risk controls have dramatically increased the cost of trading and changed the way that firms hit the market. These operational challenges make it much more expensive for banks to provide liquidity, which reduces the capacity of the industry to absorb shocks and means price moves are more dramatic.
In the past, some of the shocks to the FX market were absorbed by non-correlated flow from the non-bank buyers and sellers who steadied the market at times of stress, buffering the price action and reducing the impact. But now this type of flow has almost dried up and is often controlled by the same generation of algos being operated by the banks.
The Swiss National Bank crisis of January 2015 proved that the ongoing development of ultra-low latency platforms has led to a situation where the depth of liquidity at times is not available to support the speed of trading. A few years back, flash-crashes made the front of the newspapers, now they are a fairly regular occurrence. When liquidity is thin any sudden market move is magnified by automated trading and, before there is time to react, stop-losses are triggered and there is the potential for freefall.
After 15 years of developing systems focused on delivering the ‘best price’ we are now facing up to the reality that execution experience is as important as price. So, in today’s market, for a broker to survive and build a sustainable FX business, it must be able to deliver genuine flow and be able to manage the execution experience of the client. The need to identify ‘real’ liquidity rather than just hitting the lowest price requires smarter and better informed systems.
With the increase in the number of liquidity providers (LPs), firms have to be able to provide best execution with minimal market impact. If you are trading small clips this is not an issue. Anyone can be an LP to these firms. However, if you are placing large clips, into different market sessions, then this is now a complex and difficult task.
The problem is very clear. With limited and fragmented liquidity, if you have an LP sweeping the main venues this will instantaneously move the market, which increases the toxicity of the flow even if it is not intrinsically toxic. This in turn increases the chance that the trade will execute at a higher price, increasing the cost for the client. If there is no way to improve or increase the flow, then the only answer is to invest in technology. You have to manage the execution and fully understand the market impact you will be creating.
Liquidity providers now have to have access to very sophisticated post and pre-trade analytics systems. We strongly believe that the only way that you can achieve quality execution is through having a greater understanding of the characteristics of the venues and the performance of other liquidity providers. Introduced a few years ago, transaction cost analysis (TCA) systems coupled with market impact analytics were nice systems to have; now they are essential.
At ADS Securities, alongside our TCA tools, we have also invested in Artificial Intelligence (AI) solutions. We have developed systems which use machine-based learning, collecting data, understanding trading patterns and market responses, in order to service our clients and execute in the most efficient manner. The complexity of learning from previous trades and then providing tailored options for clients, in order to achieve best execution, can only be achieved using the latest AI systems.
The insight provided by AI systems allows us to see exactly how our clients hit the market. If you understand the impact you are having you are much better prepared to manage this and then improve the execution experience. This in return will deliver the best overall price to the client.
Through the use of technology, liquidity providers are now becoming partners to their clients. There is a combined focus on identifying and hitting the venues and providers which suit best the trading style of the client. Through AI we can evaluate trading profiles and put in place the right execution strategy for the depth and type of available liquidity.